Case Studies in Mudarabah and Musharakah

Case studies are useful to understand the concepts, and there are only a few case studies are freely available on the web. The following links will help Islamic finance students to read and practice some of the case studies in the Islamic finance. The solution manual also has been attached.

Case studies in Mudaraba contracts
Case study 1

Case studies in Mudarabah contracts
Case study 2

Case studies in Musharaka contracts
case study 1
case study 2

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Islamic Banking: Interest Rate Free or Interest Rate in Another Name – A study on Islamic Banking

The research done by Beng ,Soon Chong , Ming-Hua Liu argues that Islamic banking is not different from conventional banking practically. The study done in Malaysia elaborates that only a negligible portion is PLS based.

ABSTRACT

A unique feature
of Islamic banking, in theory, is its profit-and-loss sharing (PLS)
paradigm. In practice, however, we find that Islamic banking is not
very different from conventional banking. Our study on Malaysia shows that only a negligible portion of Islamic bank financing is strictly PLS based and that Islamic deposits are not interest-free, but are closely pegged to conventional deposits. Our findings suggest that the rapid growth in Islamic banking is largely driven by the Islamic resurgence worldwide rather than by the advantages of the PLS paradigm and that Islamic banks should be subject to regulations similar to those of their western counterparts.

Nanyang Business School, Nanyang Technological University, Singapore. 

 Faculty of Business, Auckland University of Technology, New
Zealand.

A unique feature of Islamic banking, in theory, is its profit-and-loss sharing (PLS) paradigm. In practice, however, we find that Islamic banking is not very different from conventional banking. Our study on Malaysia shows that only a negligible portion of Islamic bank financing is strictly PLS based and that Islamic deposits are not interest-free, but are closely pegged to conventional deposits. Our findings suggest that the rapid growth in Islamic banking is largely driven by the Islamic resurgence worldwide rather than by the advantages of the PLS paradigm and that Islamic banks should be subject to regulations similar to those of their western counterparts.

 1.

Introduction

The first modern experiment with Islamic banking can be traced to the establishment of

the Mit Ghamr Savings Bank in Egypt in 1963. During the past four decades, however, Islamic banking has grown rapidly in terms of size and the number of players. Islamic banking is currently practiced in more than 50 countries worldwide.1 In Iran, Pakistan, and Sudan, only Islamic banking is allowed. In other countries, such as Bangladesh, Egypt, Indonesia, Jordan and Malaysia, Islamic banking co-exists with conventional banking. Islamic banking, moreover, is not limited to Islamic countries. In August 2004, the Islamic Bank of Britain became the first bank licensed by a non-Muslim country to engage in Islamic banking. The HSBC, University Bank in Ann Arbor and Devon Bank in Chicago offer Islamic banking products in the United States. Recent industry estimates

show that Islamic banking, which managed around US$250 billion worth of assets worldwide as of 2004, is expected to grow at the rate of 15% per annum.The rapid growth of Islamic banking raises a series of important questions: Is the growth in Islamic banking a result of the comparative advantages of the Islamic banking paradigm or is it largely attributable to the worldwide Islamic resurgence since the late 1960s? Should Islamic banks be regulated differently from their western counterparts? Thus, an important question in understanding the growth — as well as the regulation and supervision — of Islamic banking is how and to what extent it differs from conventional banking.

To answer these questions, our study focuses on Malaysia, where a full-fledged Islamic banking system has developed alongside a conventional banking system. The dual banking system in Malaysia, in particular, provides a unique setting for us to compare Islamic banking practices with those of conventional banking. In addition, Malaysia, which is reported to have the largest Islamic banking, capital, and insurance markets in

the world (World Bank, 2006), is an ideal representative of Islamic banking practices in general.

From a theoretical perspective, Islamic banking is different from conventional banking

because interest (riba) is prohibited in Islam, i.e., banks are not allowed to offer a fixed rate of return on deposits and are not allowed to charge interest on loans. A unique feature of Islamic banking is its profit-and-loss sharing (PLS) paradigm, which is predominantly based on the mudarabah (profit-sharing) and musyarakah (joint venture) concepts of Islamic contracting. Under the PLS paradigm, the assets and liabilities of Islamic banks are integrated in the sense that borrowers share profits and losses with the banks, which in turn share profits and losses with the depositors. Advocates of Islamic banking, thus, argue that Islamic banks are theoretically better poised than conventional banks to absorb external shocks because the banks’ financing losses are partially absorbed by the depositors (Khan and Mirakhor, 1989; Iqbal, 1997). Similarly, the risk-sharing feature of the PLS paradigm, in theory, allows Islamic banks to lend on a longer-term basis to projects with higher risk-return profiles and, thus, to promote economic growth (Chapra, 1992; Mills and Presley, 1999).

The PLS paradigm, moreover, subjects Islamic banks to greater market discipline. Islamic banks, for example, are required to put in more effort to distinguish good customers from bad ones because they have more to lose than conventional banks. The banks also need to monitor their investments and borrowers more closely to ensure truthful reporting of profits and losses. Islamic bank depositors, furthermore, are required to choose their banks more carefully and to monitor the banks more actively to ensure that their funds are being invested prudently. Advocates of Islamic banking, therefore,

argue that a primary advantage of PLS banking is that it leads to a more efficient allocation of capital because the return on capital and its allocation depend on the productivity and viability of the project (Khan, 1986).

In practice, however, do Islamic banks operate according to the PLS paradigm? Our

study finds that Islamic banking, as it is practiced today, tends to deviate substantially from the PLS paradigm. First, we find that the adoption of the PLS paradigm of Islamic banking in Malaysia has been much slower on the asset side than on the liability side. On the asset side, only 0.5% of Islamic bank financing is based on the PLS paradigm of mudarabah (profit-sharing) and musyarakah (joint venture) financing. Islamic bank financing in Malaysia, in practice, is still based largely on non-PLS modes of financing that are permissible under the Shariah (Islamic law), but which ignore the spirit of the usury prohibition.2 On the liability side, however, mudarabah (profit-sharing) deposits, which account for 70% of total Islamic deposits, are more predominant.

Second, the mudarabah (profit-sharing) deposits, which are structured according to the PLS paradigm, are supposed to be interest-free and equity-like in theory. In practice, however, we find new evidence that shows that the Islamic deposits are not really interest-free, but are very similar to conventional banking deposits. More specifically, we find that, contrary to expectation, the investment rates on Islamic deposits are mostly

lower and less volatile than that of conventional deposits.3 Also, using the Engle-Granger error correction model, we show that (a) changes in conventional deposit rates cause changes in Islamic investment rates, but not vice-versa, (b) the Islamic investment rates are positively related to conventional deposit rates in the long-term, and (c) when the Islamic investment rates deviate far above (below) the conventional deposit rates, they will adjust downwards (upwards) towards the long-term equilibrium level. Those results imply that the Islamic banking deposit PLS practices are actually closely pegged to the deposit rate setting practices of conventional banking.

Our overall results, thus, suggest that Islamic banking, as it is practiced today in Malaysia, is not very different from conventional banking, and the alleged benefits of Islamic banking exist in theory only. There are two important implications associated with this finding: First, the key reason for the rapid growth in Islamic banking worldwide during the past decades is unlikely to be associated with the attributes of the Islamic PLS banking paradigm. Instead, its rapid growth is most likely spurred by the worldwide Islamic resurgence since the late 1960s,  which leads to a heightened demand by Muslims for financial products and services that conform to their religion.4 Second, Islamic banks in practice are similar to conventional banks, and, as such, should be regulated and supervised in a similar fashion. For example, according to the prudential regulatory and supervisory standards on capital adequacy for Islamic banking institutions, which has been issued by the Islamic Financial Services Board (2005) and adopted by Bank Negara Malaysia, all assets that are funded by mudarabah deposits (or profit sharing investment accounts) would be excluded from the calculation of the denominator (or risk-weighted assets) of the capital adequacy ratio (CAR) because it is deemed (in theory) that 100% of the credit and market risks of such assets are borne by the mudarabah depositors (or investment account holders) themselves. However, our study shows that the mudarabah

deposits, in practice, are similar to conventional banking deposits and, therefore, should not be treated any differently. As such, all assets that are funded by mudarabah deposits (or profit sharing investment accounts) should not be excluded from the calculation of

the denominator (or risk-weighted assets) of the CAR.5

The rest of the paper is organised as follows: Section 2 provides a description of Islamic banking concepts and practices. Section 3 details the Engle-Granger error-correction methodology used to study the long-term relation and short-term dynamics between Islamic investment rates and conventional deposit rates. Section 4 analyzes the results, and the final section concludes the paper.

2.Islamic Banking Concepts and PracticesIn this section, we first examine basic Islamic concepts as well as the profit-and-loss sharing (PLS) paradigm in Islamic banking. We then provide a discussion of Islamic banking practices in Malaysia.

2.1Islamic Banking Concepts and Paradigm

In Islam, there is no separation between mosque and state. Business, similarly, cannot

be separated from the Islamic religion. The Shariah (Islamic law) governs every aspect of a Muslim’s religious practices, everyday life, and economic activities. Muslims, for example, are not allowed to invest in businesses considered non-halal or prohibited by Islam, such as the sale of alcohol, pork, and tobacco; gambling; and prostitution.6 In Islamic contracting, gharar (uncertainty and risk) is not permitted, i.e., the terms of the contract should be well defined and without ambiguity. For example, the sale of fish from the ocean that has not yet been caught is prohibited.7 The prohibition of gharar is designed to prevent the weak from being exploited and, thus, a zero-sum game in which one gains at the expense of another is not sanctioned. Gambling and derivatives such

as futures and options, therefore, are considered un-Islamic because of the prohibition of gharar. More importantly, Muslims are prohibited from taking or offering riba. What constitutes riba, however, is controversial and has been widely debated in the Islamic community. Some view riba as usury or excessively high rate of interest. But the majority of Islamic scholars view riba as interest or any pre-determined return on a loan. The basis for the prohibition of riba in Islam may be traced to the common medieval Arabic practice of doubling the debt if the loan has not been repaid when due. This practice in its extreme form had led to slavery in medieval Arabia because of the absence of bankruptcy legislation that protects the borrower from failed ventures.8 Therefore, the prohibition of

riba can be viewed as part of Islam’s general vision of a moral economy.

In Islamic economics, the lender should bear the risk of the venture with the borrower

because it is deemed that neither the borrower nor lender is in control of the success or failure of a venture. Thus, a unique feature that differentiates Islamic banking from conventional banking, in theory, is its profit-and-loss sharing (PLS) paradigm. Under the PLS paradigm, the ex-ante fixed rate of return in financial contracting, which is prohibited, is replaced with a rate of return that is uncertain and determined ex-post on a profit-sharing basis.9 Only the profit-sharing ratio between the capital provider and the entrepreneur is determined ex-ante. PLS contracts, in general, allow two or more parties to pool their resources for investment purposes and to share the investment’s profit and loss.

The PLS paradigm is widely accepted in Islamic legal and economic literature as the bedrock of Islamic financing. Islamic bank financing, which adheres to the PLS principle, is typically structured along the lines of two major types of contracts: musyarakah (joint venture) and mudarabah (profit-sharing).

Musyarakah contracts are similar to joint venture agreements, in which a bank and an entrepreneur jointly contribute capital and manage a business project. Any profit and loss from the project is shared in a predetermined manner. The joint venture is an independent legal entity, and the bank may terminate the joint venture gradually after a certain period or upon the fulfilment of a certain condition.

Mudarabah contracts are profit-sharing agreements, in which a bank provides the entire capital needed to finance a project, and the customer provides the expertise, management and labour. The profits from the project are shared by both parties on a pre-agreed (fixed ratio) basis, but in the cases of losses, the total loss is borne by the bank.

Most theoretical models of Islamic banking are based on the mudarabah (profit-sharing) and/or musyarakah (joint venture) concepts of PLS (Dar and Presley, 2000). There are, however, other financing contracts that are permissible in Islam but not strictly PLS in nature. Such financing contracts, for example, may be based on murabaha (cost plus),

ijarah (leasing), bai’ muajjal (deferred payment sale), bai’ salam (forward sale), and istisna (contract manufacturing) concepts.

Murabaha financing is based on a mark-up (or cost plus) principle, in which a bank is authorized to buy goods for a customer and resell them to the customer at a predetermined price that includes the original cost plus a negotiated profit margin.10 This contract is typically used in working capital and trade financing. Ijarah financing is similar to leasing. A bank buys an asset for a customer and then leases it to the customer for a certain period at a fixed rental charge. Shariah (Islamic law) permits rental charges on property services, on the precondition that the lessor (bank) retain the risk of asset

ownership.Bai’ muajjal financing, which is a variant of murabaha (cost plus) financing, is structured on the basis of a deferred payment sale, whereby the delivery

of goods is immediate, and the repayment of the price is deferred on an instalment or lump-sum basis. The price of the product is agreed upon at the time of the sale and cannot include any charge for deferring payments. This contract has been used for house and property financing. Bai’ salam is structured based on a forward sale concept. This method allows an entrepreneur to sell some specified goods to a bank at a price determined and paid at the time of contract, with delivery of the goods in the future.

Istisna contracts are based on the concept of commissioned or contract manufacturing,

whereby a party undertakes to produce a specific good for future delivery at a pre-determined price. It can be used in the financing of manufactured goods, construction and infrastructure projects.11The acceptability of the above non-PLS modes of financing, however, has been widely debated and disputed because of their close resemblance to conventional methods of interest-based financing. Many Islamic scholars, including Pakistan’s Council of Islamic Ideology, have warned that, although permissible,

such non-PLS modes of financing should be restricted or avoided to prevent them from being misused as a “back door” for interest-based financing.

2.2Islamic Banking in Malaysia

Islamic banking was implemented in Malaysia following the enactment of the Islamic Banking Act in April 1983 and the subsequent establishment of its first Islamic bank, Bank Islam Malaysia Berhad (BIMB), in July 1983.12 The Islamic Banking Act of 1983 provides Bank Negara Malaysia (BNM), the central bank of Malaysia, with powers to regulate and supervise Islamic banks. To disseminate Islamic banking nationwide, BNM introduced the Interest-free Banking Scheme in March 1993, which allows existing banking institutions to offer Islamic banking services using their existing infrastructure and branch network. Furthermore, a second Islamic bank, Bank Muamalat Malaysia Berhad, was established in October 1999, and three new Islamic bank licences were issued to Islamic financial institutions from the Middle East in 2004 to enhance the diversity and depth of players in the Islamic financial system. As of end-2004, there were 29 Islamic financial institutions in Malaysia’s banking system, which offer a

full range of Islamic banking products and services.13

Today, Malaysia is widely believed to have the most developed Islamic financial system

in the world that operates side-by side with a conventional banking system. Besides the Interest-free Banking Scheme, Malaysia has a well-developed Islamic interbank money market, Islamic government debt securities market, and Islamic insurance market. The Islamic interbank money market, introduced in January 1994, allows Islamic banking institutions to trade in designated Islamic financial instruments among themselves. The Mudharabah Interbank Investments (MII) mechanism, moreover, allows a deficit Islamic banking institution to obtain investment from a surplus Islamic banking institution on a mudarabah (profit-sharing) basis. The Government Investment Issues (GII) market, which was introduced in 1983, is the Islamic equivalent of a conventional Treasury bill and bond market. Islamic insurance, or takaful, was first introduced in 1985 when the first takaful operator was established to fulfil the public’s need for insurance

products that are Shariah-compliant.

The growth in the Islamic banking sector in Malaysia has been rapid since the establishment of Islamic Banking Act in1983. Figure 1 captures the exponential growth

in the total assets under the management of the Islamic banking system. Starting from a small base of RM0.4 billion in 1983, the total Islamic banking assets expanded rapidly in the 1980s and 1990s at an average rate of 31% and 44% per annum, respectively. More recently, over the period of 2000 to 2004, the average growth rate in Islamic banking assets has moderated to 19% per annum, but continues to outpace the rest of

the banking system.

The total Islamic banking assets amounted to RM95.0 billion as at end-2004, accounting

for 10.5% of the total assets of the entire banking system. Table 1 provides a further breakdown of the percentage of banking assets that are under the management of the Islamic banking system by type of institutions. Islamic banks, in general, are restricted from participating in the conventional banking system, while the other financial institutions can participate in both the conventional banking system and Islamic banking system. Commercial banks, finance companies, merchant banks, and discount houses’ participation in Islamic banking is through the Interest-free Banking Scheme. Thus, we find that for Islamic banks, all their assets are managed under the Islamic banking system. For the other financial institutions, the percentage of their assets that are

under the management of the Islamic banking system is relatively small in comparison. Islamic banking assets only accounts for 7.3%, 11.4%, 6.0%, and 18.6%, respectively, of commercial banks, finance companies, merchant banks, and discount houses’ total portfolio of assets. Among the commercial banks, we find that Islamic banking assets accounts for a larger share (8.5%) of the domestic banks’ asset portfolio than that of foreign banks (3.7%). This finding may be explained by the foreign commercial banks’ lower participation rate (31%) in Islamic banking, compared with that of the domestic commercial banks (90%).

Figure 2 plots the market share of Islamic banking assets by various financial institutions

as at end-2004. Despite having only a small percentage of their asset portfolio in Islamic banking, commercial banks actually held the largest market share (56.7%) of the total Islamic banking assets. Islamic banks’ market share, in contrast, is at 26.2%, while finance companies, merchant banks, and discount houses’ market share is at 8.2%, 2.7%, and 6.3%, respectively.

Although Islamic banking is said to have made significant inroads in Malaysia, we find

that, in practice, the adoption of the PLS paradigm of Islamic banking in Malaysia has been much slower on the asset side than on the liability side. Table 2 provides a breakdown of the types of Islamic financing and Islamic deposits in Malaysia. Total financing in the Islamic banking sector amounts to RM57.9 billion as of the end of 2004. The Islamic banking sector, in general, has been expanding much more rapidly than

the conventional banking sector.14 This has resulted in an expansion of the market share for Islamic financing to 11.3% of total banking sector financing as of the end of 2004.

A breakdown of the total Islamic financing in Panel A of Table 2 shows that financing

is predominantly based on the bai’ muajjal (deferred payment sale)15 and ijarah (leasing) concepts, which account for 49.9% and 24.0% of total financing. Murabaha

(cost plus), istisna (contract manufacturing) and other non-PLS financing account for a further 7.0%, 1.2%, and 17.4%, respectively. The mudarabah (profit-sharing) and musyarakah (joint venture) financing modes, in total, amount to only 0.5% of total Islamic financing. Thus, Islamic bank financing in Malaysia, in practice, does not appear

to be very different from conventional bank lending. PLS modes of financing account for only a negligible portion of total Islamic bank financing. Islamic bank financing in Malaysia, in particular, is still largely based on the non-PLS modes of financing that are permissible under the Shariah law, but ignore the spirit of the usury prohibition.16

The adoption of the PLS paradigm, however, appears to be faster on the liability side of Islamic banking. Total Islamic banking deposits in Malaysia amount to RM72.9 billion, or 11.2% of total banking sector deposits as of the end of 2004. The breakdown of the Islamic banking deposits by type in Panel B of Table 2 shows that demand deposits, saving deposits, investment deposits, and negotiable instruments of deposit (NID) account for 17.7%, 11.6%, 57.6%, and 12.3%, respectively, of total Islamic deposits.

Demand deposits and saving deposits are structured under the al-wadiah (savings with guarantee) concept, in which a bank guarantees the repayment of the depositors’ money when demanded. The depositors of al-wadiah accounts are not entitled to any share of the bank’s profits, but the bank may — at its absolute discretion — provide returns or gifts (hibah) to the depositors periodically as a token of appreciation.

Investment deposits and NID are term deposits that operate under the mudarabah (profit-sharing) concept. Theoretically, such mudarabah deposit accounts are much riskier than conventional-banking fixed deposits for a number of reasons. First, Islamic banks guarantee neither the depositors’ capital nor the return on the deposits. Second, profit sharing under mudarabah contracts is asymmetric, i.e., the depositors share the investment profits with the bank but bear all the losses.17 Finally, mudarabah deposit accounts are equity-like from a residual claimant perspective, but the depositors of such accounts do not have any of the management and control rights typically accorded to shareholders of a bank.

The mudarabah deposits accounts, in theory, should be interest-free from an Islamic banking perspective. In practice, however, are such mudarabah contracts, which form the bedrock of the Islamic banking PLS paradigm, truly interest-free? Also, are the returns on al-wadiah (savings with guarantee) deposits independent of interest rates? To address these questions, we examined the relation between the investment rates offered by Islamic deposits and the corresponding deposit rates offered by conventional bank deposits. The next section describes the Engle-Granger error correction methodology used to study such a relation.183.

The Methodology

To determine the long-run relation as well as short-run dynamics between conventional

deposit rates and Islamic investment rates, we first carried out the bivariate Granger causality test to determine the dependent and independent variables. The following two null hypotheses were tested: (i) changes in the Islamic investment rate do not Granger cause the conventional deposit rate to change and (ii) changes in the conventional deposit

rate do not Granger cause the Islamic investment rate to change. To further ascertain that the relation between the conventional deposit rate and Islamic investment rate is not spurious, we then carried out unit root and cointegration tests. Unit root tests were based on the standard Augmented Dickey Fuller (ADF) and Philips Perron (PP) procedures, and

the cointegration test was done using the Johansen procedure. Once cointegration between the two time series was established, we then estimated their long-term relation and short-term dynamics on a maturity-matched basis.First, the long-term relationship between two time-series variables was modelled as follows:

(1)

where represents the endogenous variables, denotes the exogenous variable, and is the

disturbance term. The degree of pass-through in the long run, , measures the extent to which a change in the independent variable gets reflected in the dependent variable. The long-run pass-through is considered complete when is equal to one and incomplete when it is less than one. Second, we used the following error-correction representation to examine the short-term dynamics:

(2)where denotes the first difference, measures the short-term pass-through rate, and

is the error term. , which is the residual term associated with the long-term relation given by Equation (1), represents the extent of disequilibrium at time (t  1). 2, therefore, captures the error correction adjustment speed when the rates are away from their

equilibrium level. In the mean reverting case, the sign of is expected to be negative. Also, following Hendry (1995), the mean adjustment lag of a complete pass-through can be calculated using the following equation:(3)

4.Data and Results

Our data on the monthly series of Islamic investment rates and conventional deposit

rates were collected from the Monthly Statistical Bulletin, which is published by the Bank Negara Malaysia. The series of monthly data are aggregated and reported based on the average rates across all financial institutions.19 The sampling period was from April

1995 to April 2004. The sample size was 109 for each time series. For robustness, we examined the rates provided by two types of financial institutions: banks and finance companies.20 For each type of institutions, we compared Islamic investment rates and conventional deposit rates on savings deposits as well as time deposits of various maturities, ranging from one month to 12 months.

Table 3 provides the descriptive statistics for the sample data. The summary statistics, in particular, show that the Islamic investment rates are, on average, significantly lower than the conventional deposit rates. This finding is true for both the banks and the finance companies. Furthermore, the volatility and the minimum–maximum range of Islamic investment rates are significantly lower than those of conventional deposit rates, except

for the investment rates on Islamic banks’ savings deposits. These results are counterintuitive because the Islamic deposits, based on the PLS theory, should have higher risks than conventional deposits. A possible reason for the above results is that, in practice, the returns on Islamic deposits are administratively linked to the deposit rates offered by conventional banking. The last column of Table 3, in particular, shows

that the Islamic investment rates are highly correlated with the conventional deposit rates on a maturity-matched basis. The correlation coefficients, for example, range from 0.89 to 0.97 for the banks and from 0.88 to 0.94 for the finance companies. However, to rule out the possibility of spurious correlations, we next conducted several standard econometric tests to determine Granger causality, unit root, and cointegration.

The Granger causality test was carried out to determine if changes in Islamic investment

rates cause adjustments in the conventional deposit rates and if changes in the conventional deposit rates cause adjustments in the Islamic investment rates. Table 4 reports the results of the pair-wise Granger causality test. The results show that for each of the six maturity-matched cases, we cannot reject the null hypothesis that changes in Islamic investment rates do not cause adjustments in the conventional deposit rates. On

the other hand, we can reject the null hypothesis that changes in the conventional deposit rates do not cause adjustments in Islamic investment rates. This is true for both the banks and the finance companies. In other words, changes in conventional deposit rates cause Islamic investment rates to change, but not vice versa.

Having determined the endogenous and exogenous variables, we then carried out the standard stationarity and cointegration tests. We applied both the Augmented Dickey Fuller (ADF) and Philips-Peron procedures to test the null hypothesis of unit root against the alternative hypothesis of stationarity. Although not reported, both ADF and Philips-Peron test results show that all the data series are non-stationary in levels and stationary in first differences. The results of the cointegration tests are reported in Table 5. The Johansen cointegration test results show that all the Islamic investment rates are cointegrated with their corresponding maturity-matched conventional deposit rates at the 5% significance level for Islamic banks and at 10% for Islamic finance companies. The cointegration test results, hence, show that there is a long-term relation between the Islamic investment rate and the conventional deposit rate for both the banks and the finance companies.

The estimated coefficients of the long-term relation (Equation 1) are reported in Table 6. The results show that there exists a long-term positive relation between Islamic investment rates and maturity-matched conventional deposit rates. The adjusted R2 is very high. In the case of the banks, 79% to 93% of the variation in Islamic investment rates can be explained by changes in conventional deposit rates. The degree of long-term pass-through (1) is about 76%. In the case of finance companies, 76% to 87% of the variation in Islamic investment rates can be explained by changes in conventional deposit rates. The degree of long-term pass-through (1) is about 64%. For both banks and finance companies, the degree of pass-through for savings deposits is higher than that of time-deposits.21

The results of the short-term dynamics and the mean adjustment lags are reported in Table 7.22 The 2 estimates in Table 7, which are all significantly negative, indicate a mean-reverting process. This implies that when the Islamic investment rate is above its long-term equilibrium level, it will adjust downwards. When it is below its long-term

equilibrium level, it will adjust upwards. The mean adjustment lag (MAL) results, furthermore, show that for banks, the short-run adjustment process takes about 3.9 months to complete. For finance companies, the MAL ranges from 1.4 to 5.6 months. The MAL, moreover, is shorter for savings deposits than for the various time deposits.

Our overall results, thus, suggest that the Islamic deposits, in practice, are not very different from conventional deposits. In particular, we found that the Islamic investment rates for both the banks and the finance companies are closely pegged to the conventional deposit rates. In theory, mudarabah deposits are structured based on a “profit-sharing” basis, whereas the al-wadiah savings deposits are structured based on the “savings with guarantee” concept. In practice, however, we found that both the mudarabah deposits and the al-wadiah savings deposits are not “interest-free,” and their investment rates are closely linked to conventional deposit rates.

Furthermore, the mudarabah deposits, in theory, are supposed to be equity-like because of their PLS paradigm. Our results show that the mudarabah deposits are more debt-like than equity-like. For robustness, we examined if there is any long-term relation between the various Islamic investment rates and the return on the Malaysian benchmark KLCI equity index. Although not reported here, our results show that none of the Islamic investment rates is cointegrated with the return on the KLCI equity index and, hence, there is no long-term relation between them.23 An interesting question that arises, therefore, is why are the Islamic deposits not interest-free in practice? One explanation is that the actual implementation of the PLS paradigm is constrained by competition from conventional banking practices. Religion notwithstanding, individuals can choose to bank with an Islamic bank and/or a conventional bank. Thus, in terms of best practices, Islamic banking practices often cannot deviate substantially from those of conventional banking because of competition.

Obaidullah (2005), for example, commented that: “Islamic financial institutions

face a kind of “withdrawal risk” that mainly results from the competitive

pressures an Islamic financial institution faces from existing Islamic or conventional counterparts. An Islamic bank could be exposed to the risk of withdrawals by its depositors as a result of the lower rate of return they would receive compared to what its competitors pay. Faced with this scenario Islamic financial institutions, operating in mixed systems, may pay their investment account holders a competitive “market” return regardless of their actual performance and profitability … Failure to do this might result in a volume of withdrawals of funds by investors large enough to jeopardize the bank’s solvency.”

The Governor of the Central Bank of Malaysia, Dr. Zeti Akhtar Aziz, in fact acknowledged in her keynote address on February 15, 2006 at the 2nd International Conference on Islamic Banking, Kuala Lumpur that “[profit-and-loss sharing] places a higher degree of fiduciary risk on the Islamic financial institutions in ensuring that the investment deposits funds are managed in the most effective and efficient manner. This is further compounded by competition in managing the liquidity in the system. The profit share distributed needs to be competitive relative to that earned and paid by the conventional banks. This is important to avoid a shift of deposits and to retain the funds in the system … Given the dual banking environment, as the one in Malaysia, the ability to maximize risk-adjusted returns on investment and sustain stable and competitive returns is an important element in ensuring the competitiveness of the Islamic banking system.  Consistent with the above competition explanation, our study shows that, because of competition from conventional banking, the returns on the Islamic deposit accounts are effectively pegged to the returns on conventional banking deposits. Our results, for example, show that changes in the conventional deposit rates cause Islamic investment rates to change, but not vice versa. Estimates of the long-term relation between the two rates of return, moreover, show that many of the changes in Islamic investment rates can be explained by changes in conventional deposit rates. Short-run dynamic analysis, in addition, shows that the Islamic investment rates are mean-reverting, i.e., when Islamic investment rates deviate far above (below) conventional deposit rates, they adjust downwards (upwards) toward the long-term equilibrium level.

Another possible explanation on why the Islamic deposits are not interest-free is that, contrary to Islamic banking PLS theory, the depositors’ funds are mostly invested in non-PLS financing in practice. Under the aforementioned asset-liability matching explanation, the risk and return characteristics of Islamic deposits should be similar to that of the Islamic bank’s  financing (investment) portfolio. We are unable to study this relation directly because the return data on Islamic bank’s financing as far as we know is not available to the public. However, anecdotal evidence shows that, contrary to the asset-liability matching explanation, the Islamic bank depositors in practice do not fully share in the financing losses incurred by Islamic banks. The Bank Islam Malaysia Berhad’s depositors, for example, continued to receive “market” investment

rate of returns despite the bank’s reported loss of RM480 million (US$127 million) as at June 30, 2005 due to non-performing loans. Moreover, the above asset-liability matching explanation cannot explain why the Islamic investment rates are pegged to conventional deposit rates. More specifically, it cannot explain why the changes in the conventional deposit rates cause Islamic investment rates to change, but not vice versa. Finally, the asset-liability matching explanation cannot explain why Islamic investment rates are, on average, significantly lower and less volatile than comparable conventional deposit rates, given that Islamic banks’ financing portfolio tend to be riskier than those of conventional banks. For example, Bank Islam Malaysia Berhad’s non-performing loans (NPL) ratio of 12.46 percent as at June 30, 2005 is significantly higher than the banking industry average of 5.1 percent.24

5.Conclusions

In this paper, we attempted to establish whether Islamic banking is really different from conventional banking. In theory, a unique feature that differentiates Islamic banking from conventional banking is the PLS paradigm. In practice, however, we found that Islamic banking is not very different from conventional banking from the perspective of the PLS paradigm. On the asset side of Islamic banking, we found that only a negligible portion of financing is based on the PLS principle. Consistent with Islamic banking experiences

elsewhere, a large majority of Islamic bank financing in Malaysia is still based on non-PLS modes that are permissible under the Shariah law, but ignore the spirit of the usury prohibition. On the liability side, the PLS principle is more widely adopted in structuring Islamic deposits. Our study, however, provides new evidence, which shows that, in practice, Islamic deposits are not interest-free. There are several possible reasons for the poor adoption of the PLS paradigm in practice. First, unlike conventional banking, PLS financing encounters severe principal–agent problems. Moral hazard problems associated with ex-post information asymmetry, for example, are especially significant in PLS financing because the entrepreneur (borrower) has incentive to under-declare or artificially reduce reported profit (Mills and Presley, 1999). Also, in the case of mudarabah (profit-sharing) contracting, the entrepreneur has an incentive to undertake high-risk projects because the entrepreneur is actually given a call option whereby he or she gains on the upside but bears no losses at all on the downside. PLS financing, thus, requires more costly monitoring. Second, the adoption of PLS financing is disadvantaged by a lack of management and control rights (Dar and Presley, 2000). In mudarabah (profit-sharing) financing, for example, the bank provides all the risk capital, but the management and control of the project is mostly in the hands of the entrepreneur. The lack of management and control, in particular, accentuates the principal–agent problems associated with PLS financing. Finally, our study suggests that the adoption of the PLS paradigm is constrained by competition as well as by best practices from conventional banking. Religion notwithstanding, individuals can choose to bank with an Islamic bank and/or a conventional bank. Thus, in terms of best practices, Islamic banking practices often cannot deviate substantially from those of conventional banking because of competition. In particular, our study shows that the returns on the Islamic deposit accounts are effectively pegged to the returns on conventional banking deposits because of competitive reasons.

References

Badawy, Manuela,

2005. Islamic finance growing but regulation is an issue. Reuters News, 26 April 2005.

Chapra, M. Umer, 1992. Towards a Just Monetary System, Liecester: The Islamic Foundation.Chong, Beng Soon, Ming-Hua Liu, and Keshab K. Shrestha, 2005. Monetary transmission via the administered interest rates channel. Journal of Banking and

Finance 30, 1467-1484.

Dar, Humayon A. and John R. Presley, 2000. Lack of profit loss sharing in Islamic

banking: Management and control imbalances. International Journal

of Islamic Financial Services 2, No. 2.

Engle, Robert F. and C. W. J. Granger, 1987. Cointegration and error correction: representation, estimation and testing. Econometrica 55, 251–176.

Granger, C.W.J. and Paul Newbold, 1986. Forecasting economic time series, London:

Academic Press.Heffernan, Shelagh A., 1997. Modelling British interest rate adjustment: An error correction approach. Economica 64, 211–31.Hendry, David F., 1995. Dynamic econometrics, Oxford: Oxford University Press.

Islamic Financial Services Board, 2005, Capital Adequacy Standard for Institutions (Other Than Insurance Institutions) Offering Only Islamic Financial Services.

Iqbal, Zamir, 1997. Islamic financial systems. Finance & Development 43, 42–45.

Khan, Mohsin S., 1986. Islamic interest-free banking. IMF Staff Papers 33,

1–27.

Khan, Mohsin S., and Abbas Mirakhor, 1989. Islamic banking: Experiences in the Islamic Republic of Iran and Pakistan. IMF Working Paper No. WP/89/12,

Washington DC: International Monetary Fund.

MacKinnon, James G., Alfred A. Haug, and Leo Michelis, 1999. Numerical distribution

functions of likelihood ratio tests for cointegration. Journal of Applied Econometrics 14, 563–577.

Mills, Paul S. and John R. Presley, 1999. Islamic finance: Theory and practice,

London: Macmillan.

Obaidullah, Mohammed., 2005. Rating of Islamic financial institutions: some methodological suggestions. Working Paper – Islamic Economics Research Centre, King

Abdulaziz University.

Scholnick, Barry, 1996. Asymmetric adjustment of commercial bank interest rates:

evidence from Malaysia and Singapore. Journal of International Money

and Finance 15, 485–496.

Usmani, Maulana Taqi, 2005. Salam and Istisna, Online publication by accountancy.com.pk.

World Bank, 2006. Country brief report: Malaysia. (http://siteresources.worldbank.org/

INTEAPHALFYEARLYUPDATE/Resources/550192-1143237132157/malaysia-March06.pdf).

source : DOCFTP

THE PERFORMANCE OF MALAYSIAN ISLAMIC BANK

DURING 1984-1997: AN EXPLORATORY STUDY

Abdus Samad & M. Kabir Hassan

The study evaluates intertemporal and interbank performance of Islamic bank (Bank Islam Malaysia Berhad (BIMB) inprofitability, liquidity, risk and solvency; and community involvement for the period 1984-1997. Financial ratios areapplied in measuring these performances. T-test and F-test are used in determining their significance. The study found thatBIMB is relatively more liquid and less risky compared to a group of 8 conventional banks. Our analysis of the primary dataidentified reasons why the supply of loans under profit sharing and joint venture profit sharing is not popular in Malaysia.40% to 70% bankers surveyed indicated that lack of knowledgeable bankers in selecting, evaluating and managingprofitable project is a significant cause.I. Introduction

Evaluation of bank performance is important for all parties: depositors, bank managers and regulators. In a com-

petitive financial market bank performance provides signal to depositor-investors whether to invest or withdraw

funds from the bank. Similarly, it flashes direction to bank managers whether to improve its deposit service or loan

service or both to improve its finance. Regulator is also interested to know for its regulation purposes.

Bank Islam Malaysia Bhd (BIMB) is a single full-fledged Islamic bank in Malaysia. The important underlying force

that led to the establishment of this Islamic bank in Malaysia was the elimination of riba that is used for interest.

Tabung Haji took the initiative to do business without using interest considered as being predetermined rate of

return to a deposit. Tabung Haji is an organization for the Muslim for taking care of pilgrims to Mecca. It is

basically act as a privately to facilitate the Muslims to perform their Hajj with the feeling of minimum financial

burden. Its objective is to implement Muslim code of life (shariah) in Hajj and all business transactions. All trans-

actions in the conventional banks are based on interest or “riba” which is prohibited by Islam. Tabung Hajj wanted

to get rid of “riba” (interest). Islamic bank is sought as a solution to it. With the increase in Muslim populations and

awareness of Islamic values, there was a greater demand for Islamic bank and interest-free finance by Muslim

consumers, traders, investors, and businessmen.

Bank Islam Malaysia was established in July 1983 to meet these demands and challenges. Since then BIMB

introduced and marketed various interest free products such as Wadiah ad Dhamana account, Mudarabah,

Musharakah and others. Bank’s business has expanded over the years. Its assets and deposits have increased

from RM 325 mil to RM 4,440 mil in 1997. The financing of loans and services increased to RM 991 mil in 1997.

The number of branches increased to 75 in 1998.

However, 15 years have passed since BIMB was established. There has been no study as to how the bank

performed in liquidity, profitability, risk and solvency, as well as its commitment to economy and Muslim community

during 1984-1997. The previous studies on profitability and other measures, Samad (1998), Ariff (1989), Dirrar

(1996), Mohiuddin (1991) Sum (1995) and Hassan (1999) are far from satisfactory. These studies used neither

statistical technique nor made inter-temporal and inter-bank comparisons with three sets of conventional banks.

However, such issues of profitability, liquidity, risk and solvency; and community involvement of the bank during

1984-1997 are very important to depositors and investors. So, the present study intends to evaluate the perfor-

mance of Islamic banks using the above mentioned criteria. This study is different from the earlier studies with

respect to contents, coverage of years and methodology. In evaluating BIMB’s performances, this study also

wants to test two hypotheses. The first hypothesis states that the liquidity ratios of Islamic banks are expected to

be higher in earlier years of operation than later years due to a learning curve. The second hypothesis states that as

Islamic banking makes its inroad in the society, the volume of two truly islamic financial modes of lending

(Mudharabah and Musharakah) are expected to grow larger in later years of its operation.

Hassan (1999) examines the Islamic banking principles in theory and its application with a case study of Bangladesh.

The abundance of short-term funds compared to long-term funds available for lending is a rational response on

behalf of banks to solve informational asymmetries prevalent in credit market. In traditional finance literature, it is

shown that debt contract (murabaha) is superior to equity contract. However, equity contract can be superior to

debt contract in an economy where informational asymmetries resulting from adverse selection and moral hazard

are smaller. In Islam, business is an Ibadah (worship) and is recommended whereas riba (interest) is prohibited.

From business point of view Islamic bank is not only a firm but also a moral trustee of the depositors where deposits

are trust given to banking firm. It is naturally expected that as a custodian of trust for the depositors’ deposits,

Islamic bank is likely to be more liquid and become more solvent compared to its counterpart conventional banks.

Islamic bank management, according to Islamic ethics, is accountable to the depositors in this world and the world

hereafter for their failure to keep the trust entrusted upon them. It is, therefore, expected that the liquidity and

solvency ratio of the Islamic bank will be higher than conventional banks.

However, it is also expected that the liquidity ratio of the Islamic bank may decline during the later periods com-

pared to its early eras. As the bank grows, it acquires more skill and the art of banking business, it will keep less

liquidity and thus the liquidity ratio may decline. This paper wants to test the hypothesis that the liquidity ratio and

solvency for Islamic banks in the early periods are higher than those of later periods are.

Instead of interest based contract, Islamic bank is founded on different philosophy; and it delivers a set of distin-

guished products in the financial market. Unlike conventional banks where interest is an integral part of bank

business, Islamic bank was established to avoid interest in all bank transactions. It does not deal with interest.

Interest is avoided because “riba” is prohibited in Islam. As a business firm BIMB delivers special financial prod-

ucts that are different from the conventional banks. It delivers interest-free products. For example, trust profit

sharing (called Mudarabah) and joint venture profit sharing (called Musharakah) are two distinguished and unique

products of an Islamic bank. The important feature of this loan (Mudarabah and Musharakh) is that they are

interest-free. There are no elements of interest involved in this transaction. For the Muslims there is a great

demand for them. BIMB was established to meet these demands. With the increase in Muslim population, business

firms and entrepreneurs in Malaysia, the supply of Mudarabah and Musharakah loan was a long waited product. In

these transaction Muslims can serve religious obligation and at the same time can earn profits. With the economic

development of Malaysia and the increase in Muslim population, Islamic values, Muslim business and firms, it is

expected that demand for these products (Mudarabah and Musharakah) are likely to increase gradually over the

years. It is also expected that the information gap between bank and the bank borrowers to be minimum because

both party jointly working to maximize profit and minimize losses. Projects undertaken under the Mudarabah and

Musharaka are constantly supervised and monitored by the Islamic bank. So the chances of failures are minimized.

Based on the expectation of minimum failure it is expected that the supply of these loans will increase over the

years. This paper will test the hypothesis that the supply for this loan (Mudarabah and Musherakah) of the Islamic

bank increases over years.

The paper is organized as follows. Following introduction and rational of this study in section I, Section II describes

methodology, data and the tools for measuring bank performance. Section III provides empirical evidence and

analysis. Summary and Conclusion are provided in Section IV.

 

Please refer for reference and appendix International Journal of Islamic Financial Services Vol. 1 No.3

Developments of Islamic Banking in Pakistan & Malaysia

 

An Analytical Review

Abstract

 

This study compares Islamic banking operations currently practiced in Pakistan and Malaysia. Both countries started Islamic banking in early 1980’s but employed entirely different approaches. Pakistan attempted to convert the entire financial system in accordance with Islamic law at once at national level. Malaysia adopted the gradual application approach. It allowed Islamic and conventional banking systems to operate and to compete for deposits on parallel basis. This study examines the Pakistani and Malaysian approaches towards the implementation of Islamic banking in their respective countries. It recognizes lack of commitment and long term planning problems in case of Pakistan.  

Introduction

Islamic banking system has emerged as a competitive and a viable substitute for the conventional banking system during the last three decades. It is especially true for Muslim world where presently Islamic banking strides at two separate fronts. At one side, efforts are also underway to covert the entire financial systems in accordance to Islamic laws (Shariah). At the other side, separate Islamic banks are allowed to operate in parallel to conventional interest based banks. Pakistan and Malaysia are the two good examples of above mentioned approaches.

Both countries adopted different tracks for the same ultimate destination of developing full fledge viable Islamic financial system and produced quite interesting results. The Government of Pakistan tried to covert the entire financial system to an interest free system through presidential orders at a national level. However, the overnight practice of islamization didn’t achieve the required success. Most of the efforts have either been reversed or further developments have been stopped. Malaysia opted for the alternative gradual way of developing and implementing Islamic banking system. Starting with one Islamic bank it later allowed conventional financial institutions to offer and participate in Islamic banking products and services through their existing staff and branches. The country is now actively involved in designing new Islamic financial instruments for capital and money market transactions. This study provides the comparative analysis of implementing two opposite Islamic banking approaches, one in Pakistan and other in Malaysia along with their acquired results.

 

Origin of Islamic banking in Pakistan

 

The process of islamization the financial system of Pakistan is coincided with the globally resurgence of Islamic banking in the late seventies. Pakistan was among the three countries in the world that has been trying to implement Islamic banking at national level. This process started with presidential order to the local Council of Islamic Ideology (CII) on September 29, 1977. The council was asked to prepare the blueprint of interest free economic system. The council included panelists of bankers and economists who submitted their report in February 1980, highlighting various ways and sufficient details for eliminating the interest from the financial system of Pakistan. This report was a landmark in the efforts for Islamizing the banking system in Pakistan.

 

Origin of Islamic banking in Malaysia

 

In Malaysia, the roots of Islamic banking go back to 1963 when the government established Tabung Haji or Pilgrims Management and Fund Board. The institution was established to invest the savings of the local Muslims in interest free places, who intend to perform pilgrim (Hajj). Tabung Haji utilizes Mudarabah1 (profit and loss sharing), Musharikah2 (joint venture) and Ijara3 (leasing) modes of financing for investment under the guidance of National Fatawah Committee of Malaysia.

The first call for separate Islamic bank was made in 1980, in a seminar held in the National University of Malaysia. The participants passed a resolution requesting the government to pass a special law to setup an Islamic bank in the country. Responding to the request, the government set up a National Steering Committee in 1981 to study legal, religious and operational aspects of setting up an Islamic bank. The committee established the blue print of a modern Islamic banking system in 1983, which later enabled the government to establish an Islamic bank and to issue non-interest bearing investment certificates.

 

Initiatives Taken in Pakistan

 

The Islamic banking movement in Pakistan was a nationwide and comprehensive. As it was a mammoth task, the switch-over plan was implemented in phases. The process was started by transforming the operations of specialized financial institutions like National Investment Trust (NIT), Investment Corporation of Pakistan (ICP), and House Building Finance Corporation (HBFC) to the system conforming to the Islamic principles with effect from July 1, 1979. Separate Interest-free counters started operating in all the nationalized commercial banks, and one foreign bank from January 1, 1981, to mobilize deposits on profit and loss sharing basis. As from July 1, 1985, all commercial banking operations were made ‘interest-free’. From that date, no bank in Pakistan, including foreign banks, was allowed to accept any interest-bearing deposits. All existing deposits in banks were treated to be on the basis of profit and loss sharing. However, foreign currency deposits/loans were continued to govern on interest basis. The government meanwhile also passed Mudarabah Companies Act 1984, enabled financial institutions or business groups to setup special Mudaraba Companies in a country.

 

Initiative Taken in Malaysia

 

The establishment of Bank Islam Malaysia Berhad (BIMB) in July 1983 marked a milestone for the development of the Islamic financial system in Malaysia. BIMB carries out banking business similar to other commercial banks, but along the principles of Islamic laws (Shariah). The bank offers deposit-taking products such as current and savings deposit under the concept of Wadiah (guaranteed custody) and investment deposits under the concept of Mudarabah (profit-sharing). The bank grants finance facilities such as working capital financing under Murabaha4 (cost-plus financing), house financing under Bai’ Bithaman Ajil (deferred payment sale), leasing under Ijara (leasing) and project financing under Musharikah (joint venture). BIMB has grown tremendously since its inception. It was listed on the Main Board of the Kuala Lumpur Stock Exchange on 17 January 1992. At the end of 2003, the bank has a network of 82 branches throughout the country and staff of 1,200 employees.

 

Development of Islamic banking in Pakistan

 

The change management with regard to the introduction of new system is always a sophisticated job requiring long term planning and commitments. This is particularly true in case of present day financial system wherein the interests of the stakeholders are embedded and considered important ingredient. Only a well thought out plan with committed and continue efforts could lead to success. Unfortunately the economics managers in Pakistan lost the desired path of success. Currently, there is hardly any transaction deal in inter-banks5, intara-banks6 or the government related financial activities7 which can be called as Islamic. In the beginning of islamization process the banks expressed some anxiety to adjust them to the new system and tried to develop methods to eliminate the interest form their transactions. But the issuance of BCD circular No.13 of June 1984 allowed banks to provide finance on mark-up and on buy-back agreement basis. The technique of buy-back agreements are nothing but disguised forms of interest. With the help of new terminology the financial institutes retained the conventional methods of interest bearing finance. The Islamic modes of finances such as musharikah, mudarabah, ijara, ijara wa iktina, were not adopted in majority of the cases. The aggressively established Mudaraba Companies also failed to continue their existence; most of them are either in losses or are in the process of agglomerated with other financial institutions.

The present day financial system is largely based on ‘mark-up’ technique with or without buy-back arrangement. This procedure was, however, declared un-Islamic by the Federal Shariat Court in November 1991. Appeals were made to the Shariat Appellate Bench of the Supreme Court of Pakistan (the apex court). The Supreme Court delivered its judgment on December 23, 1999 rejecting the appeals and directing that laws involving interest would cease to have effect finally by June 30, 2001. In the judgment, the Court concluded that the present financial system had to be subjected to radical changes to bring it into conformity with Islamic laws (Shariah). It also directed the government to set up, within specified time frame, a commission and task forces for the transformation of financial system, to achieve the objective. The Court also indicated some measures related to the infrastructure and legal framework, which needed to be taken in order to have an economy conforming to the injunctions of Islam.

The Commission for Transformation of Financial System (CTFS) set-up in the State Bank of Pakistan submitted its report in August 2001 that mainly comprised the recommendation given in the two Interim reports submitted earlier in October 2000 and May 2001. Currently, a task force is working in the Ministry of Finance to suggest the ways to eliminate interest from government operations. Another task force has been set-up in the Ministry of Law to suggest amendments in legal framework to implement the Supreme Court’s Judgment.

 

Development of Islamic banking in Malaysia

 

The long-term objective of the Central Bank of Malaysia was to create an Islamic banking system operate parallel to the conventional banking system. A single Islamic bank (BIMB) did not represent the whole financial system. It required large number of pro-active players, wide range of products and innovative instruments, and a vibrant Islamic money market. Realizing the situation, the Central Bank introduced Interest Free Banking Scheme (now replaced with Islamic banking scheme (IBS) in March 1993. The scheme allowed conventional banking institutions to offer Islamic banking products and services using their existing infrastructure, including staff and branches. Since then, the numbers of IBS banking institutions have increased to 36 till the end of 2003, comprising 14 commercial banks (of which 4 are foreign banks), 10 finance companies, 5 merchant banks and 7 discount houses. The Central bank of Malaysia in its annual report (1993, page no 57) stated:

With the implementation of the interest free banking scheme, Malaysia has emerged as the first country to implement a dual banking system, whereby an Islamic banking system functions on a parallel basis with the conventional banking system”.

The aspiration to establish a comprehensive Islamic financial system has created a spill-over effect to the non-bank Islamic financial intermediaries which also started to offer Islamic financial products and services under Islamic banking scheme. Such institutions include the Takaful Companies, the savings institutions (i.e. Bank Simpanan Nasional & Bank Rakyat) and the developmental financial institutions (i.e. Bank Pembangunan dan Infrastruktur Malaysia and Bank Pertanian.

In October 1996, the Central Bank issued a model financial statement for the IBS banks requiring them to disclose their Islamic banking operations (balance sheet and profit and loss account) as an additional item under the Notes to the Accounts. The Central Bank also setup a National Shariah Advisory Council on Islamic Banking and Takaful (NSAC) on 1 May 1997. The council considers as the highest Shariah authority on Islamic banking and Takaful businesses in Malaysia. On 1 October 1999, the Central Bank issued license for second Islamic bank, Bank Muamalat Malaysia Berhad.

The country also introduced Islamic debt securities market has made its debut in 1990 with the issuance of RM 125 million Islamic bonds. Islamic Inter-bank Money Market (IIMM) on 4 January 1994 to link institutions and Islamic investment based instruments. Since then, both the markets provide variety of securities ranging from two to five years medium terms Islamic bonds to short-term commercial papers one to twelve months.

 

Present scenario of Present scenario of Islamic Banking System in Pakistan

 

Pakistan after the gap of twenty years has now decided to shift towards interest free economy in a gradual and phased manner without causing any further disruptions8. Some extracts from the affidavit submitted by the Deputy Governor of the State Bank of Pakistan (SBP) in the Supreme Court of Pakistan reflected the future policy of the Bank for the time being.

That having taken a series of steps to promote Islamic banking………. and considering all other practical problems associated with the complete transformation of the financial system, discussed herein, it is State Bank of Pakistan’s considered judgment that the parallel approach will be in the best interest of the country. This means that Islamic banking is introduced as a parallel system, of which beginning has already been made; it is provided a level playing field vis-à-vis the existing conventional banks, and its further growth and development is supported by Government and State Bank of Pakistan through appropriate actions. The approach will eliminate the risk of any major cost/damage to the economy, give a fair chance to Islamic banks to develop alongside the conventional banks, and will provide a choice to the people of Pakistan, and the foreigners doing businesses in/with Pakistan, to use either of the two systems”9.

State Bank of Pakistan issued detailed criteria in December 2001 for the establishment of full-fledged Islamic commercial banks in the private sector. Newly established Islamic bank can be listed on the stock exchange provided minimum of 50 percent of total shares must be offered to the general public. At least 15 percent of total paid-up capital should be subscribed personally by sponsor directors. Islamic bank are also required to maintain a minimum capital adequacy ratio of 8 percent based on risk weighted assets. Meezan Bank Limited (MBL) received the first Islamic commercial banking license from SBP in January 2002. At the end of 2003, MBL has a small net-work of 10 branches with total deposits of US $ 130 million.

In January, 2003 the State Bank issued detail instructions upon setting up subsidiaries and stand-alone Islamic banking branches by existing commercial banks. Accordingly six existing commercial banks including one foreign bank are allowed to open separate Islamic banking branches. Out of which eight branches of four banks have already started their operations since June 2004. Islamic banks are also allowed to maintain statutory liquidity requirements (SLR) and special cash reserve (SCR) deposits in current account with the State Bank to the maximum extent of 40% of SLR and SCR for other banks in order to avoid interest.

Some developments have also been witnessed in the capital market with regard to Islamization. During the last few years, numbers of companies have issued Term Finance Certificates (TFC) to raise redeemable capital on the basis of Musharika. The payments of profit of or sharing of loss with the TFC holders are linked to the operating profit/loss of the TFC issuing companies. Therefore, the investors assume the risk of sustaining losses proportionate to their principal amount in case of operating losses incurred by the company. In September 2002, Securities and Exchange Commission of Pakistan (SECP) also allowed the Mudaraba companies to float Musharikah based TFC’s.

Another significant development during the year 2003 is the permission to set up ‘SME Modaraba’ with the participation of about 20 Modarabah companies to undertake SME businesses in the smaller towns and distant areas. SME Modaraba will resolve the problem of the individual Modarabah companies which do not have a big branch network to reach out to the prospective clientele.

 

Present scenario of Present scenario of Islamic Banking System in Malaysia

 

Today, Malaysia has a full-fledged Islamic financial system operating parallel to conventional financial system. In terms of products and services, there are more than 40 different Islamic financial products currently available in a country. However, differentiating fixed assets and overhead expenses are problematic in case of IBS banks. Usually, an IBS bank consists of a team overseeing Islamic banking transactions. Product development, marketing and other policy issues are conducted at the respective headquarters. At the branch level, there is no delineation over Islamic and conventional transactions. Each branch officer is expected to deal with both systems. Islamic and conventional transactions share the share computers and automated teller machines (ATMs) facilities. To some extent, overhead expenses on wages/salaries, office equipment and furniture etc. can be accounted for at the bank’s headquarter, but not at the branch level. The same applies to security systems, land and office premises as these cannot be divided into the Islamic and conventional individual components (Rosley, 2003).

Overall Islamic banking industry in Malaysia has continued to register strong expansion during 2003 to account for 9.7% of the total assets of the banking system (8.9% in 2002), 10.4% of total deposits (10.2% in 2002) and 10.3% of total financing (8.1% in 2002). The improved performance was characterized by strong growth in financing activities for the purchase of transport vehicles and residential property.

The thrust of Islamic financial policy in 2004 will continue to be directed at further strengthening the fundamental essential for progressive Islamic banking industry. The Central Bank is focusing on strengthening the institutional infrastructure, enhancing the regulatory framework, strengthening the Shariah and legal infrastructure as well as enhancing intellectual capital development and consumer education. In 2003, the Central Bank of Malaysia brought forward liberalization in Islamic banking to allow three full-fledged foreign Islamic banks to be set-up in Malaysia.

 

Conclusion

 

Islamic banking has proved vital potential as a competitive and better substitute against conventional banking system in many countries of the world. Currently, two different approaches are experienced towards the development of Islamic banking. First way experienced by Pakistan, Iran and Sudan is to implement Islamic banking on a country wide and on a comprehensive basis. Second, way is to setup individual Islamic banks in parallel to the conventional interest based banks. Pakistan and Malaysia can be assumed as the two leaders of Islamic Finance. Both countries selected different tracks to achieve the same goals of developing full fledge Islamic banking but gained different results.

The Governments of Pakistan has tried to employ Islamic banking system at once at national level. The overnight exercise of islamization didn’t produce the required results due to lack of required support and continue efforts to eliminate the interest (Riba) from the economy. Most of the Islamization efforts either had been reversed or at least, further progress was stopped. Since 2001, the Central Bank of Pakistan has started adopting the gradual policies of implementing Islamic banking which Malaysia has adopted twenty years back. Al-Meezan Bank in Pakistan (fully Islamic and independent commercial bank) and full fledge separate Islamic banking branches from few commercial banks are healthy indicators for positive expectations.

Malaysia employed the gradual approach of implementing Islamic banking. Although, the country is facing problems in segregating Islamic and conventional banking fixed assets and overheads expenses but, no doubt, it has successfully developed viable Islamic financial system. After developing Islamic banking infrastructure and Islamic instruments for financial investments and liquidity management, the country is actively progressing towards the development of Islamic capital market. Malaysia is now also inviting the international players to experience its new dual banking system.

References

Ahmad, A (1997),” Towards an Islamic Financial Market, A Study of Islamic Banking and Finance in Malaysia” Research Paper No 45, Islamic Research and Training Institute, Islamic Development Bank, Jeddah.

Rosley, S A (2003), “Performance of Islamic and Mainstream Banks in Malaysia” International Journal of Social Economics, Vol 30 – 12, PP 1249 – 1265.

The Central Bank of Malaysia, (1993-2003),”The Central Bank of Malaysia, Annual Reports“, Kuala Lumpur, Malaysia.

, (1999), “The Central Bank and the Financial System in Malaysia: A Decade of Change (1989 – 1999)” the Central Bank of Malaysia Publication.

The Bank Islam Malaysia Berhad, (1994-2003),”The Central Bank of Malaysia, Annual Reports“, Kuala Lumpur, Malaysia.

State Bank of Pakistan, (1999-2003),”State Bank of Pakistan, Annual Reports“, Karachi, Pakistan.

 

 

 

1 A form of partnership where one party provides the funds while the other provides expertise and management. The latter is referred to as the Mudarib. Any profits accrued are shared between the two parties in pre-agreed ratios, while loss is borne by the provider of the capital.

2 Musharikah means a relationship established under a contract by the mutual consent of the parties for sharing of profits and losses in the joint businesses. It is an agreement under which the Islamic bank provides funds, which are mixed with the funds of the business enterprises and others. All providers of capital are entitled to participate in the management, but not necessarily required to do so. The profit is distributed among the partners in pre-agreed ratios, while the loss is borne by each partner strictly in proportion to respective capital contributed.

3 A contract under which an Islamic bank finances equipment, building or other facilities for the client against an agreed rental together with a unilateral undertaking by the bank or the client that at the end of the lease period, the ownership in the asset would be transferred to the lessee. The undertaking or the promise does not become an integral part of the lease contract to make it conditional. The rental as well as the purchase price is fixed in such manner that the bank gets back its principal sum along with profit, which is usually determined in advance.

4 Literally it means a sale on mutually agreed profit. Technically, it is a contract of sale in which the seller declares his cost and profit. Islamic banks have adopted this as a mode of financing. As financing technique, it involves a request by the client to the bank to purchase a certain item for him. The bank does that for a definite profit over the cost, which is settled in advance.

5 Money at call, purchase of trade bills,

6 Legal reserve requirements of the Central Bank

7 Investments in federal and provincial government securities, the government borrowing from the Central Bank and the financial institutions, the government lending to public enterprises

8 The decision was made in a meeting held on September 4, 2001 under the Chairmanship of the President of Pakistan attended by the officials of the Ministries of Finance and Law, Governor State Bank of Pakistan, Chairman and some members of the Council of Islamic Ideology and the Chairman of the CTFS. (Reference, State Bank of Pakistan, Annual Report, 2003, page no 193).

9 The State Bank of Pakistan, Annual Report (2003), PP 194-195.

source : kantakj

The Role of Islamic Banks in Economic

Said AL-Hallaq

Abstract

The current study is designed to investigate the practice of Jordan Islamic Bank (JIB) as a case study during the period 1980-2000. The Two Stage Ordinary Least Square has been used to capture the direct and indirect effects of Jordan Islamic Bank (JIB) on the real per capita income as a proxy to economic growth. The indirect effect of total financing and investment by (JIB) as a percentage of total credit was relatively small (0.048) compared to that by conventional bank (0.50). However, this contribution should be looked at as a good start by Islamic Banks given the fact that their experience is only 20 years compared to that of Conventional Banks.

 

1. Introduction:

The history of Islamic financial institutions in Jordan is not that old. Jordan Islamic Bank (JIB) for Finance and Investment was established in 1979 with a capital of JD (4) Million divided into (4) Million shares. The Bank’s capital increased over the years to reach JD (38.5) Million in the year 2000. The Bank aims at accommodating the diversified economical and social needs of citizens in the fields of banking, financing and investment on a non- usurious basis. This is realized through the Bank (51) branches and (11) offices, widespread all over the kingdom. The Jordan Islamic Bank has been growing rapidly; the number of clients as well as the volume of funds mobilized and invested reflects this rapid growth. The success made by Jordan Islamic Bank, however, encouraged the Arab Bank Corporation (the largest financial institution in Jordan), to establish The International Arab Islamic Bank in 1996: to conduct murabaha transactions, leasing and other investment instruments according to the Islamic principles.

 

The entrance of such an institution is expected to increase competition and reduce the monopolistic position role of Jordan Islamic Bank as the only Islamic Bank in the country. Thus, it is expected that the performance of Jordan Islamic Bank will tend to improve even better due to the presence of this new competition.

 

However, we must keep in mind that Jordan Islamic Bank is facing the following obstacles (AL- Omar and Abdel-Haq, 1996):

 

JIB has found, itself forced in order to make up the disadvantage of non being able to use the central bank as lender of last resort, to make most of it financing operations short or medium term, and to hold high levels of cash in notes in case of emergencies.

 

Lack of enough financial instruments like bonds, for example, if the (JIB) could hold listed securities issued by high-quality corporations; this could be a substitute for cash.

 

3. The JIB has found itself forced to take a tougher line on guarantees when it agrees to finance any project. The reason for this is that, in the past, some clients have tried to take advantage of the fact that the (JIB) is not able to charge interest on late payments of bills as conventional banks. There is no penalty for late payment under Islamic Law.

 

Thus, when comparing the impact of (JIB) on the economic growth of Jordan relative to conventional banks, we should not be surprised if the impact of (JIB) showed less effect. However, given the above-mentioned obstacles, this is highly expected.

 

The importance of this study comes from the fact that there is a serious lack of empirical studies on the evaluation of Islamic Banks performance compared to that of conventional banks. Munawar Iqbal (2001) has pointed this out in his attempt to compare the performance of Islamic Banks relative to conventional banks. Iqbal study was a serious and a leading study in empirical studies on Islamic Banking. Iqbal study includes in its sample 12 Islamic banks and 12 conventional banks to fulfill the purpose of his study. The conclusion reached by Iqbal showed that the in general Islamic banks have done fairly well during the period 1990-1998. This study will be an attempt to help in filling the existing gab in empirical studies on Islamic Banking.

2. Data and Methodology

 

The current study will attempt to examine the role of Jordan Islamic Bank in economic growth during the period 1980-2000. Data are gathered from the annual reports of the Jordan Islamic Bank, and the annual reports and quarterly statistical bulletins of Central Bank of Jordan. The suggested model is a simultaneous macro-econometric model consists of two behavioral equations, which will be estimated using Two Stage Ordinary Least Square methods (2SLS).

 

3. Development of Jordan Islamic Bank Activities

 

Before examining how (JIB) could contribute in the economic growth of the Jordanian economy through its financing and investment, it is worth providing an over view about the development of (JIB) during the period under consideration.

 

Table (1 -A)

 

Development of (JIB) activities during the period (1980-2000)

 

Financ-ial year

Total Assets

Total Deposits

Total financing and investment by JIB (1)

Total financing by conventional banks

(2)

(1/2)% (RAT)

Growth rates of total Assets

Growth rates of total deposits

(%)

Growth rates of total financing and investment by (JIB)

1980

15.5

11.6

6.8

563.9

1.2

1981

31.6

25.3

14.2

721 .3

2.0

103.8

118.0

108.8

1982

45.2

35.8

26.5

887.2

3.0

43.0

40.0

86.7

1983

71.5

58.6

37.6

1030.9

3.6

58.2

63.7

41.9

1984

102.0

82.8

63.0

1184.8

5.4

42.7

41.3

67.6

1985

126.8

102.8

71.0

1274.4

5.7

24.3

24.5

12.7

1986

161.7

127.6

95.5

1395.4

5.7

27.7

24.1

34.5

1987

197.4

158.5

109.0

1513.0

7.0

22.2

24.3

14.2

1988

222.6

177.8

124.1

1634.0

7.2

12.8

12.2

13.9

1989

242.3

187.2

144.1

1729.2

8.0

9.0

5.8

15.9

1990

244.8

190.3

148.9

1863.5

8.3

4.6

1.8

3.4

1991

356.7

296.9

193.1

1965.8

8.0

22.2

56.3

29.7

1992

435.3

369.5

243.1

2218.3

10.0

21.4

24.8

25.9

1993

528.3

420.6

306.7

2616.9

11.0

8.0

14.0

26.2

1994

570.0

462.1

356.1

3248.4

12.0

9.1

10.0

16.2

1995

621.9

508.5

418.2

3705.7

11.0

-0.3

9.9

17.5

1996

618.7

502.3

422.1

3920.3

12.0

5.3

1.7

7.0

1997

650.6

513.4

461.8

3979.7

11.0

8.7

2.2

9.4

1998

706.7

527.8

481.4

4285.3

12.0

7.1

2.7

4.5

1999

756.7

543.6

490.2

4466.6

11.0

12.8

3.0

2.0

2000

853.3

564.6

531.8

4546.5

12.0

11.2

3.8

8.4

Sources: (1) Central Bank of Jordan, Monthly Statistical Bulletin, different issues.

(2) Jordan Islamic Bank for Finance and Investment, Annual Reports, different issues

 

This item comprises the following: Murabaha financing, Murabaha and Musharaka financing, among after investments. The sectoral distribution of financing and financing operations comes as follows: Agriculture, Industry and mining, General trade, construction and transportation.

 

3.1 Total Deposits of (JIB)

 

It is very important to mention that total deposits rate of growth was (118%) in 1981 (see table 1), this high rate can be explained by the fact that the exiting of (JIB) increases the amounts of deposits and reduce the amounts of hoarded savings by individuals. This is because many individuals prefer to keep their savings outside the banking sector rather than engaging in any interest dealings (Rawashdeh, Hallaq, and others, 1999). On the same regard, those who used to deal with conventional banks are forced to do so in the absence of Islamic banking system. Thus, once the system has been founded most of these funds are believed to have moved to Islamic banks (Bashir, 1984). Where as, the rate of growth of total deposits started to decline after words and showed cyclical behavior (see Fig (1)).

 

 

 

However, Iqbal (2001) provides an explanation for this decline in the growth rates of total deposits mainly after 1990s due to the increase in the number of conventional banks started offering Islamic product. The Arab Bank Corporation, for example, which is the biggest financial institution in Jordan, starts to offer Islamic products and becomes a real competitor to (JIB).

 

3.2 (JIB) Total Financing and Investment:

 

The rates of growth in total investment are highly dependent on the amount of total deposits. In 1981, for example, the rate of growth reached its maximum at 108%. This could be explained by the same reasons mentioned in the previous: JIB attracted savings, which were not deposited in conventional banks for religious reasons. On the same regard, in 1990 this rate was only 3.4%, this low rate could be explained as direct impact of the Gulf War (II), which negatively effected the entire region.

 

However, This rate starts to fluctuate after 1996 due to the existence of Arab Bank Corporation as a real competitor in providing Islamic products (see Fig (2)).

 

(JIB) total investment comprises the followings: Murabaha financing, Musharakah and Murabaha financing, promissory note balance financing, Installments from leases ending in ownership. However, the sectoral distribution of total investment and financing operations come as follows: Agriculture, Industry and Mining, General trade, Construction and Transport.

 

3.3 Total Assets of (JIB)

Growth rate of total assets of Jordan Islamic Bank was 103.8% in 1981, after that it started to decline, it declined to reach 4.6 % in 1990 for the same reasons affected growth rates of both total deposits and total financing and investment (see Fig (3))

 

 

Theoretical Background:

 

4-1 Economic Growth

 

Classical economists believed in Say’s law, which argues that demand always automatically adjusts to supply. Thus, they had no worries about lack of demand, but they discussed growth only in terms of supply. In its simplest terms, classical economist visualized the supply of output as equal to amount of capital times the productivity of capital, according to the classical economists (Hunt and Sherman, 1990). The rate of growth is defined as the change in output as a percentage of current output.

 

Growth rate = change in output/ current output.

 

Classical economists, concerned as they were about economic growth, called for as much saving as possible. However, Keynes pointed out that more savings will lead to amore rapid increase of capital and consequently to more rapid economic growth only if we assume full employment and the rule of Say’s law, which claims that demand is always enough for any supply of goods and that all savings is automatically invested (Branson, 1989).

 

There is no doubt that capital formulation is a major determinant of economic growth. However, in Developed countries labor is clearly more productive the more machinery and equipment, it has to work with. Whereas in the underdeveloped the situation is different, since developing countries tend to increase their capital formation in order to stimulate economic growth with no provision is made for repairs, spare parts, and efficiently combining capital with other factors of production. For example most developing countries was fascinated by the post-Keynesian growth theories developed particularly those of Roy F. Harrod and Evsey D. Domar. These theories have been quite useful in explaining the optimum growth rate of productive capacity in developed countries. But when economists applied these analytical tools to developing countries, their conclusion was very misleading (Zuvekas, 1979). On the same regard, Robert M. Slow emphasized the same point in his latest article “ Applying Growth Theory a Cross-Countries” (June 2001).

 

In my view growth theory was conceived as a model of the growth of an industrial economy. Its parameters certainly could not be regarded as fixed forever, but may be they would need to be considered only over intervals of 30-50 years, Long enough so that the differences between endpoints could not be dominated by demand-driven business cycles. So for as I can remembers I have never applied such a model to a developing economy, because I thought the underlying machinery would apply mainly to a planned economy or a well -developed market economy.”

 

The above discussion indicates that we cannot simply apply ready made models to developing countries without any modification to suit the country in question. This study will build a simultaneous macro econometric model to capture both the direct and indirect effects of the role of Jordan Islamic Bank in economic growth for the period 1980-2000.

 

4-2 Banking Systems and Economic Growth

 

The importance of the financial system has occupied economists and policymakers since the beginning of financial history. The primary purpose of banks is to mobilize otherwise idle resources for use in productive investment. As pointed out by Fohlin (1998) a wide array of theoretical models has appeared in the growth and development literature in the past decade to formalize the link between financial-system functions and the growth of real economy. In comparison to the traditional growth models- in which output was seen as a function of capital, labor, and disembodied technological progress- the current models provide a richer framework for interpreting the potential impact of financial system. Pagano (1993) provides a simple way to summarize the newer models of finance and growth. He used several simplifying assumptions, the model yields the growth rate of output per capita as a function of three variables: savings rate, return on investment, and costs of intermediation. Thus, according to Pagano the financial institutions may enhance economic growth by raising the total quantity of financial capital available to entrepreneurs, improving the quality of investment and increasing the efficiency of intermediation lowering costs between the sources and uses of funds. On the same regard, Levine (1997) showed that as financial intermediaries, banks pay a crucial role in the operation of most economies. Thus, the efficiency of financial intermediaries can effect economic growth. Thus, we can conclude by arguing that given the fact those banks influence the accumulation of physical capital by “directing funds” to entrepreneurs who wish to invest. Such capital mobilization proceeds in two stages: Capital collection through deposit-taking and fund dispersal through loans. By repeating this process, the banking system multiplier expands the money supply and redistributes the economy’s capital. These banking functions increase the share of resources targeted to productive investment. It is worth emphasizing that Islamic Bank’s role cannot be only tied to the role of mobilizing capital, rather their role can be extended through decisions about how to lend and invest fund (i.e., the quality of investment). Thus, Islamic bank’s can influence the quality of capital formation.

 

5. The Model

 

The suggested model is a simultaneous macro-econometric model includes the following variables: real per capita income as a proxy for economic (Per) (i.e. the dependent variable), where as the independent variables are: real interest rate (Rt), Net transfer from abroad (Re), (JIB) total financing and investment as a percentage of total credits by conventional banks (RAT), Gross investment (It)-which is calculated as gross fixed capital formation plus change in stock (I)- and gross domestic product (GDP).

 

The structural form of the suggested model consists of two behavioral equations and will be estimated using the Two Stage Ordinary Least Square method (2SLS).

 

The economic growth function, measured by the change in the real per capita income, Which could be explained by the change of the following factors : investment volume, net transfer from aboard, and the total credits by conventional banks (see for example: Branson, 1989, p.528),

 

Pert = f (TCB t -1, Re t-1, It)

We can rewrite the above function in the power form as follows:

Pert = B0 TCBB1 t –1 ReB2 t-1 ItB3 eut1 ……………… …(1)

 

Where:

Per t: refers to the real per capita income as a proxy for the economic growth,

TCB t –1 = total credit by conventional banks.

Re t –1 : net transfers from abroad

It = volume of investment and

Ut1= error term

 

It must be pointed out that the lag form in the first equation was used to indicate that the effects of the transfers from abroad as well as the total credit by conventional banks takes time to prevail, the logarithmic form will be used for the above equation so as to reflect the change in dependent variable (Per t) on the independent variables (TCB t -1, Re t -1 and I t). Then using the log form,

 

Log Per t = log B0 + B1 Log TCB t-1 + B2 Log Re t-1+ B3 Log It + Ut1 …(2)

 

It must be clear that all the coefficients of the independent variables are “elasticities.” Such that the partial derivative of the dependent variable to with respect to any of the independent variables measures the responsiveness or the sensitivity of change in the dependent variable as a result of the change in the independent variable in question.

 

Table (1-B)

 

Variables used in the suggested model

 

Financial year

Real Per Capita income (Per)

Real Interest

Rate(Rt)

 

Net Transfers

From abroad

(Re)

Population

(POP)

Total Financing and Investments

By

(JIB)

Total Credits by Conventional

Banks (SDCB)

Gross

Investment

(I)

Gross

Domestic

Product

(GDP)

1980

1065.9

6.5

236.7

2.92

6.8

563.9

493.9

1151.2

1981

1352.3

6.5

340.9

3.01

14.2

721.3

701.0

1426.7

1982

1530.4

6.5

381.9

3.10

26.5

887.2

679.4

1638.1

1983

1592.4

6.5

402.9

3.20

37.6

1030.9

623.4

1765.8

1984

1691.1

6.5

457.0

3.30

63.0

1184.8

577.6

1891.4

1985

1727.8

8.5

402.9

3.41

71.0

1274.4

426.8

1969.8

1986

1754.9

8.5

414.5

3.52

95.5

1395.4

447.9

2114.6

1987

1785.2

7.5

317.7

3.63

109.0

1513.0

544.6

2162.7

1988

1812.9

7.5

335.7

3.75

124.1

1634.0

569.1

2218.4

1989

1944.6

7.5

358.3

3.88

144.1

1729.2

602.3

2329.9

1990

2038.7

8.5

331.8

4.01

148.9

1863.5

751.5

2612.5

1991

2653.6

8.5

424.6

4.15

193.1

1965.8

667.9

2779.4

1992

3770.3

8.5

514.6

4.29

243.1

2218.3

1039.4

3234.2

1993

4229.3

8.5

666.6

4.35

306.7

2616.9

1082.2

3595.7

1994

4562.7

8.5

698.7

4.39

356.1

3248.4

1451.0

3857.7

1995

4943.9

8.5

796.7

4.40

418.2

3705.7

1554.4

4246.9

1996

5279.3

8.5

1024.0

4.44

422.1

3920.3

1497.4

4711.0

1997

5548.7

7.75

1132.5

4.60

461.8

3979.7

1322.3

4954.8

1998

5795.4

9.0

983.5

4.75

481.4

4285.3

1261.0

5642.9

1999

6144.1

9.0

1035.2

4.90

490.2

4466.0

1087.8

5723.9

2000

6341.0

9.0

1268.2

5.04

531.8

4546.5

1199.0

5912.9

Source: (1) Central Bank of Jordan, Monthly Statistical Bulletin, different issues.

(2) Jordan Islamic Bank for Finance and Investment, Annual Reports, different issues

5.1.2 Investment Function

 

The investment function is measured by the change in gross investment, which could be explained by real interest rate (Rt), gross

 

Domestic product (GDP), and (JIB) total financing and investment as a percentage of total credits by conventional banks (RAT). (Maisel, 1982).

It = ƒ (Rt, GDP t, RATt)

 

We can rewrite the above function in the power form as follows:

 

It = A0 Rt A1 GDPtA2 RATtA3 eut2 ………………………………… (3)

Where:

I t : is the investment level,

Rt: is the real interest rate,

GDPt: is the gross domestic product, and

Ut2: error term

This function shows the importance of investment as a major component of aggregate demand. However, the logarithmic form will be used for the two simultaneous equations so as to measure the impact of the independent variables throughout their coefficients (i.e, elasticities) on the dependent variables under consideration, which will be used latter on to determine both direct and indirect effects of these variables.

Then,

Log I t = logA0 + A1 Log Rt + A2 Log GDPt + A3 Log RATt + Ut2 …(4)

 

6.Variables of the model and their estimation:

The model consists of two endogenous variables and six exogenous variables. Table (2) describes these variables.

 

Table (2)

 

Endogenous Variables

 

Exogenous Variables

The change in the real per capita income (Log Per).

The change in total volume of investment (Log I)

The change in transfers from a broad (Log Re).

The change in total credit by conventional banks (Log TCB).

The change in the gross domestic product (Log GDP)

The change in real interest rate (Log R)

The change in (JIB) financing and investment as a percentage of total credit by conventional banks (Log RAT)

 

The model approved to be measured after investigating the problem of identification. Both of the above two endogenous equations were over identified, thus it is more convenient to use the two stage least square approach to measure the endogenous variables of the model.

 

7. The results of the estimation

 

Using the data available in table (1-B) through the Two-Stage Least Square approach for the economic growth function and the investment function, the following tables summarizes the results:

 

Table (3)

 

The economic growth function (Log Per) (Dependent variable)

 

Independent variables

Estimated coefficients

T – values

– Total credit by conventional banks (Log DCB t-1 )

Gross investment (Log I)

Net transfers from a board (Log Re)

 

0.50

0.22

0.24

 

(6.83)*

(4.26)**

(8.5)*

Notes: (a) F-test = 179, constant = 2.2, (b) *: Significant at 1% level

**: Significant at 5% level

 

Table (4)

 

The investment function (Log I) (Dependent variable)

 

Independent variables

Estimated coefficients

T – values

Gross domestic product (Log GDP).

(JIB) total financing and investment as a percentage of total credits by conventional bank (Log RAT)

real interest rate (Rt)

 

0.96

 

 

0.16

-0.14

(3.43)**

 

 

(0.45)

(-0.25)

Notes: (a) F-test= 112, constant = -1.12, (b) **: Significant at 5% level

 

From the above two tables we can reach the following conclusions:

Both the change in total investment (Log I) and the change in net transfers from abroad (Re) prove to have a positive and significant impact on the dependent variables (Log Per) such that if gross investment increased by 1 % the per capita income will increase by 30 %, whereas the increase in net remittances by 1 % will lead to increase per capita income by 34%.

 

The impact of total credit by conventional banks proves to be insignificant, even though it shows a positive coefficient. This can be explained by the fact that conventional banks are interested only in getting its predetermined rate of interest regardless of the type of projects borrowers will choose to implement. In Jordan, unfortunately, the large portion of investments is devoted to the service sector, where it reduces the chances of increasing Job opportunities and thus reduce the level of employment

 

The impact of change in (JIB) financing and investment as a percentage of total credit by conventional banks was positive but insignificant. This can be explained by the fact that most of its financing operations (short or medium terms), and it has to hold high levels of cash in notes in case of emergencies a long with the lack of enough financial instruments as in the case of conventional banks.

 

Also we must remember that (JIB) was established 20 years ago, so it is unfair to compare its impact on the economy with those effects of conventional banks, which have been established in Jordan for more than 50 years ago.

 

8. The reduced form

 

The structured form is always used to explain the direct effect of the independent variables of any model on the dependent variables, but the reduced form explains both direct and indirect effects of independent variables on the dependent variables. This study will use reduced form to analyze the direct effects of Jordan Islamic Bank financing and investments on the total investment and the indirect effect of Jordan Islamic Bank financing and investment on real per capita income.

 

Log Per = 2.23 + 0.50 Log DCB (-1) + 0.30 Log I + 0.34 Log Re

Log I = -1.11 + 0.96 Log CDP + 0.16 Log RAT – 0.14 Rt

 

In order to capture the indirect effects on the independent variables on the change in real per capita income (Log Per). We can use the chain rule to do that (Chiang, 1988) as follows:

 

1. d Lper = δ LI * d L Per = (0.96) (0.30) = 0.288 > 0

d GDP δ GDP dLI

 

It is very clear that total investment will effect positively the level of GDP, which will in turn effect the per capita income. That is, the indirect effect of GDP on per will associate positively, through the level of investment.

 

2. d Lper = δ LI * d L Per = (0.16) (0.30) = 0.048 > 0

d LRAT δ LRAT dLI

 

The indirect effect of total investment as a percentage of total financing and investment by (JIB) is relatively small, only (0.048) on the real per capita income. It must be looked at as a good start. However, the direct impact of total credit by conventional banks is (0.50), which is higher than that of the (JIB); This can be justified by the fact of (JIB) scale and the surrounding economic environment mentioned in the introduction of this paper (see for example Vogel and Hayes, 1998).

 

3. dLper = δ LI * dL Per = (-0.14) (0.30) = (-0.042) <0

dLRt δ Rt dLI

 

The direct effect of real interest rate was negative (-0.14), this result is consistent with the negative relationship between the interest rate and the level of investment

 

The indirect effect of real interest rate on the real per capita income negative and relatively small due to the fact that real interest rate was fixed and controlled by the monetary authority for a very long period of time (Hallaq, 1997).

 

9. Conclusions

This study was designed to investigate the practices of Jordan Islamic Bank (as a case study) during the period of 1980-2000. The Two Stage Ordinary Least Squares were used to capture the direct and indirect effects of (JIB) on the real percept income, which has been used as proxy to economic growth. Several results been found.

 

Growth rates of total deposits, total assets and total financing and investment by (JIB) in 1981 showed a very high growth rates at an absolute sense due to the fact that many individuals were hoarding their private savings outside the banking formal sector rather than engaging in any interest dealings. After wards, these growth rates start to take a normal pattern of growth. The Arab Bank Corporation in Jordan, the biggest financial institution starts to offer Islamic product, which effects the growth, rates after 1995.

 

The study used a simultaneous macro-econometric model to capture the direct and indirect effects on economic growth during the period under consideration:

 

The suggested model consists of two behavioral equations and will be estimated using the two stage ordinary least square method.

 

The economic growth function, which is measured by the change in real per capita income, could be explained by the change in the following variables. Investment, net transfers from a broad and total credits by conventional banks.

 

The Investment function, which is measured by the change in gross investment, was explained by the following variables: real interest rate, gross domestic product, and total financing and investment by JIB as a percentage of total credits by conventional banks.

 

9.3.The statistical results showed that

 

9.3.1 Both changes in total investment and net transfers from abroad proved to have a positive and significant impact on the change in real per capita income.

 

The total credit by conventional banks proved to be insignificant, even though it shows a positive coefficient. This can be explained by the fact that a large portion of such credits goes to the service sector. Thus, their direct effect on real per capita income was small and insignificant.

 

The impact of the change in (JIB) financing and investment as a percentage of total credit by conventional banks on the investment level was positive but insignificant. This is expected since most of (JIB) financial operations was short or medium, so that the bank has to hold high levels of cash in notes in case of emergencies.

 

The reduce form has been used to explain both direct and indirect effects of the independent variables on the dependent variable.

 

Volume of investment affects positively the level of gross domestic product, which in turn affects the real per capita income. Thus, the indirect affect of GDP on per capita income will associate positively through the level of investment.

 

9.4.2 The indirect effect of total financing and investment by (JIB) as a percentage of total credits by conventional banks was relatively small (0.048) on the real per capita income. But this rate must be looked at as a good start by Islamic banks compared to (0.50) by conventional banks total credits.

 

The indirect effect of real interest rate on the real per capita income was negative and relatively small due to the fact that real interest rate was fixed and controlled by the monetary authority for a very long period of time.

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Branson, H. William (1989), Macroeconomic: Theory and Policy, New York: Harper & Row, Publishers.

Fohlin, Caroline (1998), ‘Banking Systems and Economic Growth: Lessons from Britain and Germany in the Pre-World War Era’, Review, Federal Reserve Bank of Saint Louis, 80 (3), 27-54

Hallaq-al, Said and Nadera Murayan (2000), ‘The Impact of Private Investment in Economic Growth: The Case of Jordan’, Dirasat, University of Jordan, 22(2),359-374.

International Institute of Islamic Economics (IIIE)(1999), IIIE’s Blueprint of Islamic Financial System, Islamabad: International Islamic University, Islamabad.

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Chair, Economics & Islamic Banking Dept., Yarmouk University, Irbid, Jordan.