money, islamic banks and the real economy - … · · 2011-10-05money, islamic banks and the real...

221

Money, Islamic Banksand

the Real Economy

Abdul Ghafar IsmailProfessor of banking and financial economics

Universiti Kebangsaan Malaysia

CENGAGELearning'

Australia • Brazil • Japan • Korea • Mexico* Singapore* Spain • United Kingdom • United States

Contents i XI

Contents

Par t I : MONEY AND THE ISLAMIC BANKING SYSTEM

CHAPTER 1: AN INTRODUCTION TO MONEY AND THE ISLAMICBANKING SYSTEMThe History of Islamic BankingThe Components of the Islamic Banking SystemThe Principles of Money and Islamic Banking

Principle 1: Money as CapitalPrinciple 2: Rabbul mal and Mudarib RelationshipsPrinciple 3: Risk SharingPrinciple 4: Markets Set Prices and Generate ProfitsPrinciple 5: Islamic Banking StabilityPrinciple 6: Islamic Banks as Agents for Economic Growth

The Organization of This BookSummaryKey Terms and ConceptsQuestions

CHAPTER 2: MONEY AND THE PAYMENT SYSTEMThe Islamic Concept of Money

OwnershipUtilization

The Functions of MoneyThe medium of exchangeThe Store of Value

The Payment SystemCash PaymentsPayments by ChequeGiro PaymentsPlastic CardsCharge CardsCredit CardsDebit Cards

Credit CardsHow does a credit card work in practice?Credit Card AssociationsIssuersAcquirersVisa MembershipIslamic Credit Card

Wholesale Payments System

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XII • Contents

EFPOSTCHIPSAutomated Clearing House (ACH)

Money Flows in the EconomyBase MoneyBank Money and Bank ReservesThe Transaction Money Supply

SummaryKey Terms and ConceptsQuestions

CHAPTER 3: FINANCIAL INSTRUMENTS, FINANCIAL MARKETS,AND ISLAMIC BANKING INSTITUTIONSLinkages between Financial Instruments, Markets, and

InstitutionsFinancial Instruments

The Creation of Financial ContractsUses of Financial InstrumentsFinancial MarketsThe Role of Financial Markets

The Structure of Financial MarketsMoney MarketCapital MarketForeign Exchange Market

Islamic Banking InstitutionsThe Functions of Islamic Banking InstitutionsThe difference between Islamic Banks and

Conventional BanksBusiness OperationsSocial and Ethical Responsibilities


Par t I I : ISLAMIC BANKING OPERATIONS

CHAPTER 4: INTRODUCTION TO BASIC CONTRACTS INISLAMIC BANKINGProhibition of RibaBasic Contracts in Islamic BankingContract of Profit-Sharing

MudarabahDefinitionBasis of MudarabahTypes of MudarabahTerms and Conditions of Mudarabah Contract

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1Contents i

Modern Applications of MudarabahMusharakah

DefinitionBasis of MusharakahTypes of MusharakahTerms and Conditions of Musharakah ContractsModern Applications of Musharakah

Contract of SaleIjarah

DefinitionBasis of IjarahTypes of IjarahTerms and Conditions of Ijarah ContractsModern Applications of Ijarah

Ju'alahDefinitionBasis of Ju'alahTerms and Conditions of Ju'alah ContractModern Applications of Ju'alah

Bay'al-MurabahahDefinitionBasis of Bay' al MurabahahTypes of Bay' al-MurabahahTerms and Conditions of Bay' al-Murabahah ContractModern Applications of Bay' al Murabahah

TransactionsBay' Salam

DefinitionBasis of Bay' SalamTypes of Bay' SalamEssential Elements of Bay' Salam ContractModern Applications of Bay' Salam

Istisna'aDefinitionBasis of Istisna'aTerms and Conditions of Istisna'a ContractModern Applications of Istisna'a

Qard ulhasanahDefinitionBasis of Qard ul HasanahTerms and Conditions of Qard ul Hasanah ContractModern Applications of Qard ul Hasanah

Bay' Bithaman AjilDefinitionBasis of Bay' Bithaman AjilEssential Elements of Bay' Bithaman Ajil Contract

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Modern Applications of Bay' Bithaman AjilBay As-Sarf

DefinitionBasis of Bay' As-SarfTerms and Conditions of Bay' As-Sarf ContractModern Applications of Bay' As-Sarf

Contract of DepositsAl Wadi'ah

DefinitionBasis of al-Wadi'ahTypes of Wadi'ahEssential Elements of Wadi'ah ContractModern Applications of Wadi'ah

Contract of WakalahWakalah

DefinitionBasis of al-WakalahTypes of al-WakalahTerms and Conditions of al-Wakalah ContractModern Applications of al-Wakalah

Contract of Gift (Hibah)DefinitionBasis of HibahTerms and Conditions of Hibah ContractsModern Applications of Hibah

Contract of SecurityAI-Kafalah

DefinitionBasis of al-KafalahTypes of al-KafalahTerms and Conditions of al-Kafalah ContractModern Applications of al-Kafalah

Al-HawalahDefinitionBasis of al-HawalahTypes of al-HawalahTerms and Conditions of al-Hiwalah ContractModern Applications of al-Hiwalah

Al-RahnDefinitionBasis of al-RahnEssential Elements of al-Rahn ContractModern Applications of al-Rahn


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CHAPTER 5: SOURCES OF FUNDSThe Balance Sheet of Islamic banksComponents of the Balance SheetDemand Deposits

Wadiah Yad Dhamanah Current Account-iFeaturesMechanismHibah DistributionExample of Hibah Rate

Mudarabah Current Account-iFeaturesMechanismProfit Distribution

Saving DepositsWadiah Yad Dhamanah Saving Account-i,

FeaturesMechanismHibah DistributionExample of Hibah Rate

Mudarabah Saving Account-iFeaturesMechanismProfit Distribution

Wakalah Saving Account-iFeaturesMechanism

Investment DepositsGeneral Investment Accounts-i

FeaturesMechanismProfit DistributionExample of Mudarabah GIA Return

Special Investment Accounts-iFeaturesMechanismProfit Rate DeterminationExample of Indicative Rate of Return

Specific Investment Account-iFeaturesMechanismProfit Distribution

Deposit-Structured AccountsCommodity Murabahah Deposits

FeaturesMechanism

Return

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XVI • Contents

CHAPTER 6:

Example of the Rate of Return on Commodity 114Investment-Linked Deposits 114

Features 114Mechanism 115Returns 116

Inter-bank Placement-i 117Profit Equalization Reserve 117Investment Risk Reserve 118Shareholder Funds 119

Paid-up Capital 119Reserves 119

Statutory Reserves 120Financing Loss Reserves 120

Other Capital Accounts 121The Importance of the Sources of Funds Components 121Summary 122Key Terms and Concepts 122Questions 122

USES OF FUNDS 125Cash and Cash Equivalents 126

Vault cash 126Required reserves 126Due to other Islamic Banks 127

Sales Receivables 127Bay'-Bithaman Ajil Financing 128

Features 128Mechanism 128Calculation of Profit Margin for Financing Activities 129Calculation of Interim Profit for Partial Disbursement 131

Working Capital Financing-i 134Features 134Mechanism 134

Salam Financing 136Features 136Mechanism 136

Leasing-i 137Features 137Mechanism 138Rental Payment 139

Hire Purchase-i 140Features 140Mechanism 140Rental Payment 142

Trade Financing 142Letter of Credit-i 142

Contents 4 xvii

CHAPTER 7:

Trust Receipt-iExport Credit Refinancing-iBank Guarantee-i (BG-i)Shipping Guarantee-i (SG-i)Accepted Bills-i

Personal FinancingBay' al-Inah FinancingTawarruq Financing

Equity FinancingDiminishing Musharakah Property Financing-i

FeaturesMechanismIjarah Payment

Mudarabah Project FinancingFeaturesMechanism

Investment in SecuritiesIslamic Inter-bank Cheque Clearing SystemInter-bank Acceptance-iBank Negara Negotiable Notes-iIslamic Negotiable InstrumentsSale and Buy Back Agreement

FeaturesMechanismCalculation of Proceeds

Government Investment IssuesIslamic Treasury BillsCagamas Mudarabah Bonds

Islamic Accepted BillsImports and local purchasesExports and Local sales

Islam Private Debt SecuritiesIslamic Commercial PapersSukuk

FeaturesMechanismReturn

Fixed AssetsInvestment in SubsidiariesThe Importance of the Uses of Funds ComponentsSummaryKey Terms and ConceptsQuestions

INCOME STATEMENTComDonents of Income Statements

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Total Income 172Income from Financing and Investment 172Operating Income 174

Dealing Income 174Fees and Commissions 175

Expenses 176Administrative Expenses 176

Personnel Expenses 177Fixed Asset Expenses 177Other Expenses 178

Allowances 178Objectives of Allowances 178Types of Allowances 179Measurement of Allowances 180

Reserves 180Profit Equalization Reserves 180Investment Risk Reserves 181

Total Distributable Income 181Net Distributable Income 181Income Attributable to the Depositors and Shareholders 184

Profit After Zakat and Taxation 185Zakat 185Taxation 186

Net Profit 187Retained Earnings 187Cash Dividend 187Islamic Bank Profit Model 187Summary 189Key Terms and Concepts 189Questions 189

Par t I I I : ISLAMIC BANKS PERFORMANCE

CHAPTER 8: EVALUATING ISLAMIC BANK PERFORMANCEInternal Performance

Business PlanningStrategic PlanningDistribution ChannelTechnologyPersonal Development

External PerformanceMarket ShareRegulatory ComplianceShariah CompliancePublic Confidence

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Contents 4 XIX

Aligning Internal-External Performance Frameworks with MarketValuations 202

Summary 204Key Terms and Concepts 205Questions 205

CHAPTER 9: ANALYZING ISLAMIC BANK PERFORMANCE WITHFINANCIAL RATIOS 207Financial Performance Indicators 209

Profitability and Sustainability Indicators 209Efficiency and Productivity Indicators 210Portfolio Quality Indicators 211Growth and Outreach Indicators 212Financial Structure Indicators 213

Interpreting Performance Indicators - Some Examples 214Earnings Performance Ratios 215

Net Income to Average Assets 215Provision for Financing Losses to Average Assets 215Net Realized Gains or Losses to Average Assets 216Net Income to Average Assets 217

Assets Quality Ratios 217Non-current Financings to Total Financings 217Allowance for Financing and Lease Losses to Non-current

Financings 218Capital Adequacy Ratios 218

Cash Dividends to Net Income 218Tier 1 Capital to Average Assets 218

The Evaluation of Financial Ratios 219Summary 222Key Terms and Concepts 222Questions 223

Part IV: RISK MANAGEMENT 225

CHAPTER 10: UNDERSTANDING RISK 225Unique Features of Islamic Banks 226Defining Risk 227

Market Risk 228Foreign exchange risk 228Profit rate risk 228Equity risk 229

Credit Risk 229Operational Risk 230Liquidity Risks 230Equity Investment Risks 231Displaced Commercial Risks 231

1 XX j 1 • Contents

Compliance RiskInventory Risk

Risk Profiles in an Islamic BankMarket Risk ProfilesCredit Risk ProfilesOperational Risk ProfilesLiquidity Risk ProfilesEquity Investment Risk ProfilesDisplaced Commercial Risk Profiles


CHAPTER 11: MANAGING RISKRisk Management AgendaRisk Management Tools

Economic CapitalFormulaHypothetical Example

Expected LossConceptual FrameworkExample

Value-at-RiskEstimating VaRExample

Stress TestingDefinition and ApplicationsTechniques for Stress TestingExample on Macro Test of Islamic Banks

Regulatory RiskSources of Regulatory RisksThe Costs and Consequences of Regulation

Current Practices to Mitigate RisksProfit Equalization ReserveVariable rates of ReturnsProfit RiskSecuritization

Profit Rate SwapSummaryKey Terms and ConceptsQuestions

P a r t V: REGULATORY AND SUPERVISORY ENVIRONMENTS

CHAPTER 12: REGULATIONFrom Law to Regulation

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Reasons for Regulations 269Safety and Stability 270Promoting Competition and Efficiency through a

Banking Structure 270Public Confidence 271Market Discipline 271Basis for Monetary Policy 272

Policy Issues Related to Regulations 273Regulations on Islamic Bank Activities and

Banking-Commerce Links 273Regulations on Domestic and Foreign Islamic Banks Entry 274Regulations on Capital Adequacy 275Deposit Insurance Design 275Regulations on Easing Private Sector Monitoring of

Islamic Banks 276Government Ownership of Islamic Banks 277

Legal Framework 277The Central Bank Ordinance 1958 277Islamic Banking Act 1983 278Banking and Financial Institutions Act 1989 279Government Investment Act 1983 281

Regulatory Environtments 281Guideline on the Shariah Advisory Council 282Guideline on Corporate Governance 283Guideline on the Presentation of Financial Statements 285Guidelines on Rate of Return 285Guidelines on Total Insured Deposits 285Guidelines on Islamic Banking Products 286

Accepted Bills-i 286Sells and Buys Back Agreement Transactions 287


CHAPTER 13: SUPERVISION 291The Philosophy 292The Objectives 293Risk-based Supervision 293

The Approach 294The Framework 296

Stage 1: Full Scope Examination of Islamic Banks 296Stage 2: Impact Assessment of Islamic Banks 296Stage 3: Risk Assessment of Islamic Banks 297Stage 4: Development of a Risk Mitigation Programme 305Stage 5: Evaluation and Validation 306

XXII • Contents

Stage 6: Communicating the Results of the Assessmentand Risk Mitigation Programme to theIslamic Bank 306

Stage 7: Implementation of Risk Mitigation Programme,On-Going Assessment and Response toRisk Escalation 307

The Supervisory Processes 308Off-Site Surveillance 308

Pre Conditions for Effective Off-Site Surveillance 308Off-Site Surveillance Processes 309

On-Site Examination Process 312Examination Planning 312Examination Programme 313Examination Procedures 314

Stress Testing 317Stress Testing Procedure 317Stress-Testing Tools 318

Supervisory Concerns 318Capital Adequacy and Earning Sustainability 318Continuous Surveillance 319

Monitoring System 319Risk Management Tools 322

Supervisory and Enforcement Actions 325Summary 326Key Terms and Concepts 326Questions 327

Par t V I : CAPITAL, LIABILITIES, ASSETS AND OFF-BALANCE SHEETMANAGEMENT 329

CHAPTER 14: CAPITAL MANAGEMENT 329Definition of Islamic Bank Capital 330

Equity 330Reserves 331Capital Hybrid 332

Role of Islamic Bank Capital 333Regulator's View on Capital Adequacy 334Capital Standards 335Capital Base 336

Risk-Adjusted Assets 338Conversion from Off-Balance Sheet 339

Shareholders' Viewpoint on Capital Adequacy 340Capital Structure Decision 340Asset Investment Considerations 341Securitization 343

Contents 4 XXIIIii li

Dividend PolicyCapital Allocation

Fulfilling the Capital RequirementsCapital Adequacy Standard

Basis for Minimum Capital Adequacy RequirementsThe Proposed Minimum Capital Requirements

Shariah Compliant InstrumentsProvisions for Operational RiskAdjustment to the Capital Ratio Denominator

Innovations in Capital InstrumentsExample


CHAPTER 15: LIABILITIES MANAGEMENTStructure of Islamic Bank Liabilities

Deposit Sources of FundsDemand DepositsSavings DepositsInvestment DepositsStructured Deposits

Non-Deposit Sources of FundsDeposits and Placements of Islamic Banks and Other

Financial InstitutionsProfit Equalization Reserves

Managing the Net Distributable IncomeLiquidity Management

Factors that Affect LiquidityFinancial Market AccessFinancial ConditionBalance Sheet Structure

Liquidity MeasurementSummaryKey Terms and ConceptsQuestions

CHAPTER 16: ASSETS MANAGEMENTStructure of Islamic Bank AssetsFinancing

Types of FinancingFinancing Business FirmsFinancing for ConsumersFinancing for Real Estate

Financing by ContractsRegulation of Financing

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PricingCost-plus PricingPrice-leadership ModelCredit-scoring Systems and Risk-based PricingFirm Profitability Analysis

Investment in SecuritiesInvestment Instruments Held by Islamic BanksFactors Affecting Choice of Investment Securities

Expected Rate of ReturnTax TreatmentMarket RiskDefault RiskLiquidity Risk

Reserve ManagementLegal ReserveShort-term Funds Position Management

Prudent Risk Management Creates Value for Islamic BanksSources of Credit RiskMeasuring Credit Risk

Micro ApproachMacro Approach


CHAPTER 17: OFF-BALANCE SHEET MANAGEMENTMotives for Moving Assets Off the Balance SheetFee Income as a Catalyst of Off Balance Sheet ActivitiesOff-Balance Sheet Activities

Financial GuaranteesLetter of GuaranteeStandby Letters of CreditLetter of Comfort and Letter of Awareness

RemittancesStanding InstructionSecurities and Fund Services

Telegraphic TransferTele-bankingTravelers' and Bankers' ChequesCashier's Order /Local Demand Draft

SecuritisationCross Currency SwapSummaryKey Terms and ConceptsQuestions

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Contents 4 XXV

Part V I I : THE REAL ECONOMY 443

CHAPTER 18: THE ECONOMICS OF THE ISLAMIC BANKINGSYSTEM 443The Role of Islamic Banks 444

Labour-Based Transactions 444Financial-Based Transactions 445Implementing Shariah Law 446Pooling Savings 446Channeling Funds 447Custodian, Payment System Access and Accounting 448

Information Disclosure 449Economic Contribution 450

Extending Contribution to General EconomicDevelopment 451

Benefiting Employees, Customers and Communities 451Islamic Banks - Value Added Wealth 451Summary 453Key Terms and Concepts 454Questions 454

CHAPTER 19: THE CENTRAL BANK 455The History of the Central Bank 456The Role of Bank Negara 458The Objectives of the Central Bank 459

Low and Stable Inflation 459High and Stable Real Growth 460Financial System Stability 461Profit Rate and Exchange-Rate Stability 462

The Organizational Structure of the Central Bank 463The Board of Directors 463The Governor and the Deputy Governors 464The National Shariah Advisory Council 464Organizational Structure 465

Evaluating the Central Bank's Organizational Structure 465Independence from Political Influence 465Decision Making by Committee 467Accountability and Transparency 469

Policy Framework 471Meeting the Challenges: Creating an Islamic Financial Center 472

MIFC 472INCEIF 475


• Contents

CHAPTER 20: MONETARY POLICY TRANSMISSION 477The Transmission Mechanism 478

Monetary Policy Transmission Mechanism 478The Impact of Monetary Policy Impulses on the Economy 479

Monetary Policy Tools 482Structure of the Bank Monetary Policy Committee 482The Tools 483

Open Market Operations 483Overnight Policy Rate 485Statutory Reserve Requirements 485

Objectives of Monetary Policy 487The Role of Operating Targets 491Rate versus Quantity Variables as Operating Targets 492The Role of the Monetary Policy Strategy for the

Choice of the Operating Target 494Operating Targets and Monetary Policy Tools 495

The Impact of Monetary Policy Targets on the Bank's BalanceSheet 496

Fiscal Operations and the Central Bank's Balance Sheet 501Summary 504Key Terms and Concepts 505Questions 506

CHAPTER 21: THE ISLAMIC BANKING SYSTEM AND THE REALECONOMY 507Circular Flow 508Understanding of the Exchange Economy 510

The Production Function 510The Demand Curve 513The Supply Curve 516Equilibrium and the Determination of Output

and Inflation 519Money Flow and Balance Sheet in the Exchange Economy 522The Size and Composition of the Balance Sheet as

Intermediate Targets 525Bank Capital 525Bank Liabilities 525Monetary Base 525How does the Monetary Policy Work? 526

Evolving Role of Islamic Financial Institutions 529Summary 530Key Terms and Concepts 530Questions 530

money, islamic banks and the real economy - … · · 2011-10-05money, islamic banks and the real...

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