CHAPTER 2: FRAMEWORK OF

ISLAMIC FINANCIAL SYSTEM

Mohammad Salleh Abdul SahaRazizi bin Tarmuji

razizi.uitm.edu.my

أضعافا با الر تأكلوا ال آمنوا الذين أيها ياتفلحون لعلكم الله واتقوا مضاعفة

“Hai orang-orang yang beriman, janganlah kamu memakan riba dengan berlipat ganda

dan bertakwalah kamu kepada Allah supaya kamu mendapat keberuntungan”.

(QS. Ali ‘Imran : 130).

ISLAM

AQIDAH(Belief)

SHARIAH

Ibadat(man to Allah)

Muamalat(man to man)

POLITICAL ACTIVITIES

ECONOMIC AVTIVITIES

BANKING & FINANCIAL ACTIVITIES

SOCIAL ACTIVITIES

AKHLAK

A financial institution that operates with the objectives to implement the economic

and financial principles of Islam in the banking arena.

Islamic Banking Act 1983: “..a company which carries on Islamic banking business means banking busines

whose aims and operation do not involve any element which is not approved by the

religion of Islam…”

DEFINITION OF ISLAMIC BANKING

PAST YEAR

Main concern

Ensuring justice

and equity in

economy

PLS are major

features

Prohibition of riba’

Financial transactio

n

2.1.1Historical

development Of

Islamic Banking

HISTORICAL DEVELOPMENT OF ISLAMIC BANKING

In the world

1st stage: when it still remained an

idea

2nd stage: it already

became a reality

In Malaysia

1st phase: 1963-1992

2nd phase: 1992-2000

3rd phase: 2001-2010

PAST YEAR

1st stage: Interest-free banking as an idea.. Anwar Qureshi (1946), Naiem Siddiqi (1948) and

Mahmud Ahmad (1952), followed by a more elaborate exposition by Mawdudi in 1950, including all the writings of Muhammad Hamidullah (1944, 1955, 1957 and 1962), have proposed a banking system based on the basis of profit and loss sharing (Mudharabah) rather than interest

In the world

1963

• As a result from the pioneering efforts of Ahmad El-Najjar, the first Islamic banking was established in Egypt named Mit Ghamr Local Savings Bank

1972

• First commercial bank (without using syariah) in Egypt, named Nazir Social Banks Nasser Social Bank was established and its objectives are more to social than commercial

1974

• The first bank explicitly based on Shariah principles was established by the Organization of Islamic countries (OIC), named Islamic Development Bank (IDB) with the mission to provide funding to projects in the member countries

1975-1979

• Several Islamic banks came into existence, including:

• 1975-Establishment of first Islamic private commercial bank named Dubai Islamic Bank

• 1977- Faisal Islamic bank of Sudan, Faisal Islamic Bank in Egypt and Kuwait Finance House

• 1979- Bahrain Islamic bank

1983-1984

• Iran and Sudan introduced 100% islamic banking system

2nd stage: Interest-free banks became reality

1st phase : 1963-1992

1963 •Establishment of the Pilgrims Fund Board•It is saving mechanism -Malaysian Muslim set aside regular

funds to cover them performing annual pilgrimage

1969 •Pilgrims Fund Board combined with Pilgrim’s Management Fund Board/ Lembaga Urusan dan Tabung Haji (LUTH)

1980•Several parties were calling for establishment of Islamic bank

due to resurgence that happened in the Middle East•Eg: Malaysian government had being offered by Bumiputra

Economic Congress to set up Islamic Bank in this country

In Malaysia

1981•Set up National Steering Committee (NSC), chaired by Raja

Mohar Badiozaman•NSC undertake study and make recommendations to

government on all aspects relating Islamic Bank in Malaysia, including legal, religious and operational aspects.

•LUTH take over the secretarial functions

1983 •July 5: NSC submitted their report to government•The first Islamic bank was established in Malaysia- Bank

Islam Malaysia Berhad (BIMB) under Islamic Banking Act 1983

Recommendation made by NSC on Islamic Banking

Government should establish an Islamic Bank according to Shariah

Bank should incorporated as a limited company under Company Act 1965

New Islamic banking act (administered by BNM) must be established to license and supervise Islamic Bank.

Each bank must has their own Shariah Supervisory Board to supervise and ensure there is shariah operation in Islamic bank

2nd phase : 1993-2000 • 4 March: Interest-Free banking Scheme (IFSB)/

Skim Perbankan Tanpa Faedah (SPTF) was launched on a pilot basis involving Malayan Banking Bhd. , Bank Bumiputra Malaysia Berhad and United Malayan Banking Corporation Bhd.

• July: Commercial banks, merchant banks and finance companies begun to offer Islamic banking products and services under the Islamic Banking Scheme (IBS banks).

1993

• BNM establish Shariah Advisory Council (SAC) which consist of academicians and Shariah experts in Islamic Banking and Takaful

• Role:• Harmonize different opinion in Shariah• Advise BNM• Analyze Shariah aspects of new products submitted by banking institutions and takaful companies

May 199

7

• The IFSB/SPTF was replaced with Islamic Banking Scheme (IBS)/ Sistem Perbankan Islam

1st December

1998

• Establishment 2nd Islamic Bank, Bank Muamalat Malaysia Berhad ( merger between Bank Bumiputera Malaysia Bhd. + Bank Commerce (M) Berhad

1st October 1999

3rd phase : 2001-2010

•1 March: BNM had launched Financial Sector Master Plan (FSMP) – incorporated a comprehensive 10 year

master plan for Islamic banking and Takaful•Declaration of Labuan as International Offshore

Financial Centre (IOFC) to promote Malaysia as International financial system

2001

•Establishment of Islamic Financial Services Board (IFSB) in Kuala Lumpur2002

•Financial liberation of Islamic Banking sector with the issuance of three new islamic license under IB Act

1983, from Middle East to Islamic financial institution

2004

•Implementing dual banking system•Become the first nation have full-fledge Islamic system operating side-by-side with conventional

system

Today

2.1.1 Structure of Islamic Bank

No. Structured Functions1. The Board of

Directors(BOD)1. Set the banks policies and to monitor the

management’s faithfulness to them.2. To plan the future and resolve current

problems.3. To give advice, make judgment and

oversee the commitment of corporate resources.

4. To assets, select and if necessary, replaces the top management.

5. To define the responsibilities and limits of authority of the managements.

2. The Shariah Supervisory Board.

1. To ensure all of the operation compliance(obedience) to Shariah.

3. The executive Committee that comprise of a few members of the Board of directors who meet frequently.

1. To dispose of matters which cannot wait for the holding of the next BOD meeting.

No.

Structured Functions

4. Management-CEO 1. Responsibilities and authorities to the Departmental Head that report to him especially monitoring their performance and giving guidance.

2. Giving report to BOD through its Executive Committee.

5. Sub-committees:Consists of various department:a) Customer Serviceb) Credit and Marketingc) Foreign Exchanged) Treasury and Accountse) Administrationf) Systems where

computers are usedg) Internal audith) Organisation and

Researchi) Legal and Shariah

affairs.

The sections in the department:

a) deposit,cash,domestic bill,business developmnt

b) Mkt & credit analysis/administration/operationc) Export,import,foreign bill & collectiond) Corporate acc,customer

acc,budget,treasury,central bank return.e) Personnel,general services.

2.1.1 Differences between islamic

bank and conventional bank

FEATURES CONVENTIONAL BANK

ISLAMIC BANK

Risk sharing Predetermined rate of interest

:Promotes risk sharing between investor and the bank & the bank and the entrepreneur : pre-agreed proportion

Emphasis to product Credit worthiness Under PLS-return only if there is a profit-more concern with soundness of the project and managerial competence of the entrepreneur.

Moral Dimension Little attention to the moral implications of the activities

All economic agents have to work within the Islamic moral value.

FEATURES CONVENTIONAL BANK

ISLAMIC BANK

Relationship between bank and customer

Creditor(bank) and debtor(customer)

Partner. E.g:if based on al-mudharabah, the bank become as a capital provider and customer as entrepreneur. They will share profit based on ratio agreed and losses in term of money will bear by bank capital provider(bank)

Shariah Supervisory Board

Don’t have shariah advisory board. They review solely by certified auditors.

They have Shariah supervisory board to ensure and approve all of the transaction and operation based on shariah.

Zakat payment Don’t pay zakat but only pay tax as required by the government

Pay zakat as a relegious obligation and tax required by the government

2.1.2Takaful

Wakala model: The principal-agent relationship

Mudaraba model: Partnership

Combination model: Principal-agent relationship and partnership

TAKAFULArabic word (لتكافل)-‘guaranteeing each other’ /

‘joint guarantee’. It is an Islamic insurance concept which is grounded in Islamic muamalat, observing

the rules and regulations of Islamic law

Basic concept• Social solidarity• Cooperation• Mutual indemnification of losses among members

Principles• Policyholders (Takaful partners) cooperate among

themselves for their common good. (wakalah)• Every policyholder pays his subscription to help those

who need assistance (tabarru’)• Losses are divided and liabilities spread according to the

community pooling system. (mudharabah)• Uncertainty (gharar) is eliminated concerning

subscription and compensation.• It does not derive advantage at the cost of others. (no

riba’)

History of Takaful in Malaysia

• The development of takaful industry in Malaysia was inspired through the establishment of Bank Islam Malaysia Berhad (BIMB) in 1983

1983

• The Takaful Act was drafted

• 29/11-Syarikat Takaful Malaysia Berhad (Takaful Malaysia)was established as the pioneer takaful operator in Malaysia

1984 • Takaful Malaysia offering Family Takaful & General Takaful Business

1985

1996• 30th July-

The Company was listed on the Main Board of Bursa Malaysia

1997• Ist May-

BNM established NSAC on Islamic banking and Takaful

2001• Acquisition

of Syarikat Takaful Indonesia (STI), the holding company of PT Asuransi Takaful Umum (ATU) and PT Asuransi Takaful Keluarga (ATK)

2006• August-

there is HSBC Amanah Takaful in Malaysia

2009 - 45 branches nationwide with total assets over RM4.37 Billion at Group

level

2010 - Launched Retail Strategy: APF agency

structure, 3-tier products (Takaful myInvest, Takaful

myGemilang, Takaful myGraduan); Launched Takaful myCare Centres

CRITERIA INSURANCE TAKAFUL

Elements of Gharar(uncertainty),Maisir(gambling), and riba’

Contains all these elements

Prohibited all of this elements because it’s contradict with Shariah.

Shari’ah supervision Don’t have Shariah Supervision

Objective is to ensure that the activities of company are carried out according to principles of Shari’ah.

CRITERIA

TAKAFUL INSURANCE

Accounts the account known as Al-Tabarru’ which means donation, the other one is treated in line with the principle of Al-Mudharabah.

The account is known as general insurance account and life insurance account of fund.

Bonus Specifies from the outset how the profits from .Takaful

investment are to be shared between the

operator(mudharib) and the participants(sahib ul-mal).Based on principles of Al-

Mudharabah, the ratio could be 5:5 or 6:4 or 7:3 as agreed between the participant and

the operator.

May offer bonus or profit in general terms only especially with profit policies, there is no exact specification with regard

to the profit-sharing in contract. It may also decide to give or not to give bonus for

any particular year depending on the result of the investment return. The rate of bonus can vary from year to year up to the discretion of the Board of

Directors of the company.

CRITERIA

TAKAFUL INSURANCE

Investment The funds shall be invested in any interest free from Shari’ah justified scheme. The entire procedure shall comply the guidelines of the Shari’ah investment return must not be driven by any unethical commercial activities.

The funds may also be invested in an interest-based scheme. They can also be invested in any scheme or project, which may not be supported by the Shari’ah discipline.

Nature The entire operation aims at paying the way of

brotherhood, solidarity and mutual cooperation.

The operation aims a commercial gain on the basis of the principles of

business.

CRITERIA

TAKAFUL INSURANCE

Regulations Regulations affecting Takaful are based on the Divine sanction (Qur’an and Hadith)

Insurance law is based on the human thoughts and cultures

Contract Participants own the Takaful fund and managed by the operator. Participants give up individual rights to gain collective rights over contribution and benefits

Insurance is a buy-sale contract in which policies

are sold and the policy holders are the purchasers.

2.1.3ISLAMIC CAPITAL

MARKET(ICM)

A global leader in Islamic Capital Market As at end of 2007 Total Islamic Bond Market- US$37 billion 134 Islamic Unit Trust Funds with a net

asset value of US$5.2 billion First Global Sukuk - Guthrie’s US$150

million in 2001 First Global Sovereign Sukuk – Malaysian

Government’s US$600 million in 2002

ISLAMIC CAPITAL MARKETYEAR CRITICAL MILESTONES1990:

1993

SHELL MDS Sdn. Bhd. Issued the first Islamic bond.Launch of first Islamic Equity unit trust fund by Arab-Malaysian Unit Trust Bhd

1994: BIMB Securities Sdn. Bhd was established.

1995: SC established ICM Unit.

1996: • The Syariah Advisory Council (SAC) was established.• RHB launched the country’s first Islamic equity index,

comprising shares of KLSE main board companies.

1997: The Sc introduced an official list of Syariah approved securities traded on the KLSE.

1999: The KLSE launched the country’s second Islamic equity index, the KLSE Syariah index (KLSI)

YEAR CRITICAL MILESTONES2000: • The SC imposed the requirement to engage

independent Syariah adviser for issuing Islamic Bonds, as stipulated in the Giudelines on the Offering of Private Debt Securities.

• Islamic Bond Fund launched.2001: •The minister of Finance launched the Capital

Market Masterplan. •2001: Issuance of the world’s first Global Sukuk by Kumpulan Guthrie

2002: • First Global Islamic Bond Issues.• The Prime Minister launched the book,

resolutions of the Securities Commission SAC.

• 2002: Issuance of the world’s first Global Sovereign Sukuk

2003: The Malaysia Government, in its Federal Budget 2004, allowed tax deduction for 5 years on expenses occurred in the issuance of Islamic bonds, based on Syariah principles of Istisna’.

Islamic Capital Market Statisitics as at 30 June 2012

Shariah-Compliant Securities on Bursa Malaysia

June 2012 June 2011

No. of Shariah-compliant securities+ 825 847

% to total listed securities 89% 89%

Latest market capitalisation:

Shariah-compliant (RM billion) 864 836

Total market (RM billion) 1,368 1,342

% of Shariah-compliant securities to total market 63% 62%

Islamic Capital Market products and services

versus conventional marketConventional IslamicMoney Market Instruments

Commodity Murabaha

Fixed income bonds SukukEquities Shariah compatible

equitiesUnit Trust/Mutual Funds

Same as conventional

Real Estate through Investment Funds (un-restricted leverage )

Real Estate with Shariah acceptable leverage

Stock broking Islamically acceptable broking

STRATEGIC INITIATIVES TAKEN BY SC TO MEET THE OBJECTIVES OF ESTABLISHING MALAYSIA AS INTERNATIONAL ISLAMIC CAPITAL MARKET CENTER Facilitate the development of various competitive products and services

related to the Islamic Capital Market (ICM) Created an independent market mobilize Islamic funds effectively. Enhance the value recognition of Malaysia ICM internationally. To ensure and maintain public confidence in the ICM by ensuring the

range of product and services offered by market participants are in full compliance with Syariah principles.

To review and provide guidance on all matters related to ICM to ensure conformity with Syariah principles.

to advices SC on all matters related to the comprehensive development of the ICM and function as a reference for issue related to ICM

THE ROLE OF SHARIAH ADVISORY COUNCIL (SAC) OF SC

established by the SC in 1996 under section 18 of the Securities Commission Act 1993 (SCA)

To ensure harmonization and standardization of Syariah rulings to avoid possible divergence of Syariah scholars in the country.

Method that used by the SAC to introduced the ICM instruments.

* To study the validity of conventional instruments used by the local capital market from the Syariah perspective. * Formulating and developing new financial instruments based on Syariah principles.

SHARIAH- COMPLIANT SECURITIES BY THE SHARIAH

ADVISORY (SAC) OF THE SUCURITIES COMMISSIONS

(SC) In classifying securities which are listed on

Bursa Malaysia, SAC received input and support from the SC.

The SC gathered information on the companies from various sources.

The SC, through the SAC, continue to monitor the activities of all companies listed on Bursa Malaysia to determine their status from the Shariah perspective.

NON- COMPLIANT SECURITIES The SAC has applied a standard

criterion in focusing on the activities of the companies listed on Bursa Malaysia.

The companies that considered under non- compliant securities if they are involved in the following core activities:

a) Financial based on riba(interest).b) Gambling and gaming.c) Manufacture or sale of non- halal products.

d) Conventional insurance that containing element of gharar(uncertainty).e) Entertainment activities that are non- permissible according to Shariah.f) Manufacture or sale of tobacco-based product or related products.g) Stockbroking or share trading in Shariah non- compliant securities.h) Other activities deemed non- permissible according to Shariah.

CAPITAL MARKET PRODUCT1) Call warrants. * Underlying Assets * Exercise Price * Exercise Period2) Transferable Subscription Rights (TSR).3) Crude Palm Oil Future Contract. * Among the related issues to this instrument are gambling, gharar, bai’ ma’dum and ‘iwadh.4) Composite Index Future Contract.

ISLAMIC INTERBANK MONEY MARKET(IIMM)

INTRODUCTION THE ISLAMIC MONEY MARKET IS INTEGRAL TO

THE FUNCTIONING OF THE ISLAMIC BANKING SYSTEM.

PROVIDE THE ISLAMIC FINANCIAL INSTITUTIONS WITH THE FACILITY FOR FUNDING AND ADJUSTING PORTFOLIOS OVER THE SHORT-TERM AND SERVING AS A CHANNEL FOR THE TRANSMISSION OF MONETARY POLICY.

FINANCIAL INSTRUMENT AND INTERBANK INVESTMENT WOULD ALLOW SURPLUS BANKS CHANNEL FUNDS TO DEFICIT BANKS, ALSO MANTAINING THE FUNDING AND LIQUIDITY MECHANISM NECESSARY TO PROMOTE STABILITY IN THE SYSTEM.

IIMM WAS INTRODCED ON JANUARY 3, 1994 AS A SHORT-TERM INTERMEDIARY TO PROVIDE A READY SOURCE OF SHORT-TERM INVESTMENT OUTLETS BASED ON SYARIAH PRINCIPLE.

THE ISLAMIC BANKS AND BANKS PARTICIPATING IN THE ISLAMIC BANKING SCHEME (IBS) WOULD BE ABLE TO MATCH THE FUNDING REQUIREMENTS EFFECTIVELY AND EFFICIENTLY.

BANK NEGARA MALAYSIA (BNM) ISSUED THE GUIDELINES TO FACILITATE PROPER IMPLEMENTATION OF THE IIMM.

DEVELOPMENT OF BNM OPERATIONS IN MALAYSIAN ISLAMIC INTER BANK

MONEY MARKET 18 DEC 1993: ISSUE THE GUIDELINES ON THE IIMM. 03 JAN 1994: IIMM WAS INTRODUCED. 13 FEB 1996: MUDHARABAH INTERBANK INVESTMENT.21 SEP 1999: MUDHARABAH MONEY MARKET TENDER.29 NOV 2000: BANK NEGARA NEGOTIABLE NOTES-

BASED ON BAI AL- INAH. 15 JUN 2001: GOVERNMENT INVESTMENT ISSUE BASED

ON BAI AL-INAH AND ISSUE ON BEHALF OF THE GOVERNMENT MALAYSIA.

01 OCT 2OO1: CIRCULAR ON WHEN ISSUE WAS ISSUED BY BNM TO ALL THE ISLAMIC BANKING INSTITUTIONS.

15 APR 2002: WADIAH ACCEPTANCE BASED ON AL WADIAH.

01 AUG 2002: BNM ISSUED GUIDANCE NOTES ON SELL AND BUY BACK AGREEMENT TO ISLAMIC BANKING INSTITUTIONS.

21 DEC 2002: SELL AND BUY BACK TENDER VIA FULLY AUTOMATED SYSTEM OF ISSUING/ TENDERING SYSTEM (FAST) WAS INTRODUCED.

17 SEPT 2004: ISSUANCE OF THE FIRST MALAYSIAN ISLAMIC TREASURY BILLS.

08 OCT 2004: LAUNCHING OF ISLAMIC INTERBANK MONEY MARKET WEBSITE BY THE GOVERNMENT.

16 FEB 2006: INAUGURAL ISSUANCE OF SUKUK IJARAH BANK NEGARA MALAYSIA.

08 Feb 2007 Introduced Commodity Murabahah Programme (CMP). 

21 Apr 2009 The Association of Islamic Banking Institutions Malaysia (AIBIM), have unanimously adopted two standardized interbank master agreements for Islamic deposit-taking and placement transactions. 

02 Jul 2009 Inaugural issuance of Bank Negara Monetary Notes Murabahah (BNMN-Murabahah). 

17 Aug 2009 Bursa Malaysia – launched Bursa Suq Al Sila – a world’s first, end-to-end Shariah-compliant commodity trading platform that is able to facilitate commodity-based Islamic financing and investment transactions under the Shariah principles of Murabahah, Tawarruq and Musawwamah using Malaysia's commodity, crude palm oil (CPO). 

21 Aug 2009 The Corporate Murabahah Master Agreement (CMMA), a standard document for deposit taking between financial institutions and corporate customers, was launched by Association of Islamic Banking Institutions Malaysia (AIBIM). 

17 Sep 2009 Association of Islamic Banking Institutions Malaysia – launched two standardized documents for deposit taking and placement transactions. The move significantly enhanced Islamic interbank activities by improving efficiency, limit misunderstandings and reducing the cost of Islamic banking transactions. 

24 Nov 2009 The Association of Islamic Banking Institutions Malaysia (AIBIM) has launched the standard Wakalah Placement Agreement (WPA). The move is aimed at standardising the agreement for deposit placements by corporate customers with Islamic financial institutions (IFIs) and for interbank placements among IFIs under the Wakalah concept.

TYPES OF INSTRUMENT OF IIMM1. MUDARABAH INTER-BANK INVESTMENT (MII).2. WADIAH INTERBANK-BANK ACCEPTANCE.3. GOVERNMENT INVESTMENT ISSUES (GII).4. BANK NEGARA MONETARY NOTES- i (BNMN-i).5. SELL AND BUY BACK AGREEMENT (SBBA).6. CAGAMAS MUDHARABAH BONDS (SMC)7. WHEN ISSUES (WI).8. ISLAMIC ACCEPTED BILLS (IAB)9. ISLAMIC NEGOTIABLE INSTRUMENTS10. ISLAMIC PRIVATE DEBT SECURITIES11. AR RAHNU AGREEMENT-I (RA-i)12. SUKUK IJARAH BANK NEGARA MALAYSIA

(SBNMI).

PAST YEAR

DIFFERENCES – ICM vs IIMM

ISLAMIC INTER- BANK MONEY MARKET

ISLAMIC CAPITAL MARKET

Short- term investment (< 1 year) Long- term investment (> 1 year)

No organized exchange only cover the counter (OTC) trading.

Organized exchange of Bursa Malaysia.

Governed and supervised by the BNM.

Governed and supervised by SC.

The IIMM covers inter-bank transaction as the following:1) Inter- bank trading in Islamic

Financial instruments.2) Islamic inter-bank investment.3) Islamic inter-bank cheque

clearing system.

ICM between both retail (individual) and institutional investors with corporations.