IB1005 DEPOSITS AND FINANCING PRACTICES OF ISLAMIC FINANCIAL INSTITUTIONS CHAPTER 1 : ISLAMIC BANKING

1. COMPILED BY HAMDAN HJ IDRIS, BSc Econs, MBA (Islamic Banking & Finance) Certified Professional Trainer (MIM) Industry Expert INCEIF PRESENTED BY HJ MAHMUD HJ BUNTAT, MBA (AUOL, UK), DBM (Swansea Inst., UK), CIL (UIA) Part-time Lecturer (INCEIF) Former Head of Islamic Banking Division, OCBC Bank (Malaysia) Bhd IB1005DEPOSITS AND FINANCING PRACTICES OF ISLAMIC FINANCIAL INSTITUTIONSCHAPTER 1 : ISLAMIC BANKING

2. STRUCTURE OF ISLAMIC TEACHING ISLAM Akhlak (Moralities & Ethics) Aqidah (Faith & Beliefs) Aqidah (Faith & Beliefs) Aqidah (Faith & Beliefs) Aqidah (Faith & Beliefs) Aqidah (Faith & Beliefs) Aqidah (Faith & Beliefs) Aqidah (Faith & Beliefs) Aqidah (Faith & Beliefs) Aqidah (Faith & Beliefs) Aqidah (Faith & Beliefs) Aqidah (Faith & Beliefs) Aqidah (Faith & Beliefs) Aqidah (Faith & Beliefs) Aqidah (Faith & Beliefs) Aqidah (Faith & Beliefs) Aqidah (Faith & Beliefs) Aqidah (Faith & Beliefs) Shariah (Practices & Activities) Syariah (Practices & Activities) Syariah (Practices & Activities) Syariah (Practices & Activities) Syariah (Practices & Activities) Syariah (Practices & Activities) Syariah (Practices & Activities) Syariah (Practices & Activities) Syariah (Practices & Activities) Syariah (Practices & Activities) Syariah (Practices & Activities) Syariah (Practices & Activities) Syariah (Practices & Activities) Syariah (Practices & Activities) Syariah (Practices & Activities) Syariah (Practices & Activities) Syariah (Practices & Activities) Syariah (Practices & Activities) Syariah (Practices & Activities) Syariah (Practices & Activities) Ibadah (Man-to-God worship) Muamalat (Man-to-man activities) Muamalat (Man-to-man activities) Muamalat (Man-to-man activities) Muamalat (Man-to-man activities) Muamalat (Man-to-man activities) Muamalat (Man-to-man activities) Muamalat (Man-to-man activities) Muamalat (Man-to-man activities) Muamalat (Man-to-man activities) Muamalat (Man-to-man activities) Muamalat (Man-to-man activities) Muamalat (Man-to-man activities) Muamalat (Man-to-man activities) Muamalat (Man-to-man activities) Muamalat (Man-to-man activities) Muamalat (Man-to-man activities) Political Activities Political Activities Political Activities Political Activities Political Activities Political Activities Political Activities Political Activities Political Activities Economic Activities Economic Activities Economic Activities Economic Activities Economic Activities Economic Activities Economic Activities Economic Activities Economic Activities Social Activities Social Activities Social Activities Social Activities Social Activities Banking & Financial Activities Banking & Financial Activities Banking & Financial Activities Banking & Financial Activities 2

3. SOURCES AND APPLICATION OF SHARIAH LAWS SHARIAH LAWS (Practices & Activities) PRIMARY SOURCES SECONDARY SOURCES QIAS (Analogical deduction provided detailed understanding derived from Al-Quran and Al-Sunnah) Al-QURAN (The Holy Book) IJMAK ULAMA (The Consensus of opinion of Islamic scholars) Al-SUNNAH (The Practice of Prophet Muhammad [Peace be Upon Him]) 3

4. LEVELS OF SHARIAH LAWS 4

5. Chapter 1: Islamic Banking Islamic Banking Law Some basic principles have to be considered; 1. Riba must be eliminated as the basis of banking transactions. 2. Activities financed by banks must be lawful. 3. Modes of financing should be based on their economic merit. 4. The objectives of the banking system should be related to the economic ideals of Islam.

6. “ Whereas legitimate trade or industry increases the prosperity and stability of men and nations, dependence over usury would merely encourage a race of idlers, cruel bloodsuckers and worthless fellows who do not know their own good and therefore are akin to madmen” (Al-Baqarah verse 2 :275)

7. The prohibition of interest essentially implies that there can be no gain without risk- sharing, which implies that if someone wishes to get returns he must be liable for the loss. • No risk, no gain is actually the basic juristic principle of Shariah.

8. Prohibition of gharar – excessive uncertainty about subject matter. • Prohibition of Maisir/Qimar – game of chance, or zero sum game… ”one gains at the cost of others.” • Quran for prohibition on gambling (Al-Baqarah verse 2 : 219 and Al-Maidah verse 5: 90,91). • Gambling is a form of gharar

9. Philosophy of Islamic Finance • Prohibition of riba and permission to trade (Al-Baqarah verse 2: 275) • Towards asset-backed business & transaction • Real transaction or the sale of goods etc

10. 1. Avoiding interest and Gharar, 2. Adhered to Shariah Principles, e.g. mudharabah, musharakah, murabaha, salam, Istina’ 3. The business, investment and gain are permissible (Halal) 4. Contribute to Zakat (Alms or Tithe) Guiding Principles

11. 1.Profit – Risk with Resposibility Shariah maxim “ Al Kharaj bi-al-Daman” or “ Al Ghunum bil Gurm” , the criterion of legality of any return on capital, meaning that one has to bear loss if he wants to get any profit over his investment. 2.Islamic Banks dealing in goods & document and not money. Money only as medium of exchange Basic Operational Requirements

12. 2. Islamic Banks dealing in goods not money – deal in goods & document, money only as medium of exchange 3. Avoiding gambling & game of chance. 4. Transparency & Documentation. 5. Additional risks face by Islamic Banks - asset, market risk, Shariah & non-compliance risks, withdrawal risk, legal risk. Basic Operational Requirements (Continued)

13. To achieve a full-fledged Islamic Banking system none of the above Four Guiding Principles can be ignored, but legislators may choose to either tackle the four aspects all at once or in phases according to circumstances. • Specific legislation has been developed for Islamic banking and finance, for example in Bahrain and in Malaysia, as well as more comprehensive amendments in Pakistan, but only partial amendments in the U.K. or none at all in the U.S.

14. The rulebook for Islamic banks covers areas such as licensing requirements, capital adequacy, risk management, business conduct, financial crime and disclosure/reporting requirements. • Interestingly, under the Principles of Business (PB) for Islamic banks, Article 1.1.1 (Integrity) states, “All relevant persons should be straightforward and honest in their services and conduct. Integrity is not just limited to honesty but also includes fair dealing and full disclosure of all relevant information. Banks' management must safeguard not only the interests of shareholders of the bank, but also those of the Profit Sharing Investment Account (PSIA) holders.”

15. Bank Negara Malaysia (BNM) regulates banks generally through the Banking and Financial Institutions Act 1989 (BAFIA) and specifically, Islamic Banks via the Islamic Banking Act of 1983 (IBA). • Islamic banking business ”means banking business whose aims and operations do not involve any element which is not approved by the Religion of Islam” (refer to attached BAFIA and IBA legislation). Regulatory Requirements

16. The terms “banking business” itself is not defined in the IBA although the terms is defined in BAFIA as the business of:– • Receiving deposits on current account, deposit account, savings account or other similar account; • Paying or collecting cheques drawn by or paid by customers; and • Provision of finance;

17. Such other business as the Bank [BNM], with the approval of the Minister, may prescribe. • The terms ‘Religion of Islam’ is very broad and leaves open the interpretation as to which school of law should apply (historically, the majority of Muslims, including those in South East Asia adopted the Ottoman civil code, the Majallah

18. Additionally, in the act is that dispute resolution in Islamic banking cases comes within the jurisdiction of the civil courts (and not under the Shari’ah courts as might be expected). • Neither the IBA or BAFIA exclude the application of civil law to Islamic banking transactions, or that Islamic law shall apply exclusively to such transactions

19. Also the IBA does not limit the business of Islamic banking to stand-alone operators, in fact, in Section 124 of BAFIA, it empowers conventional financial institutions to carry on Islamic banking business to the same extent as an Islamic bank, and thus conventional banks to be permitted to operate Islamic window platforms.

20. Islamic banks resolve this problem by offering full repayment of the investment but informing the customer how much should be repayable to comply with the risk-sharing formulation. • This allows customers to choose not to accept full repayment if their religious convictions dictate otherwise.”

21. In other words, when face with a loss the customer is presented with the option to accept the loss, which if suddenly not accepted, would require the bank to guarantee full capital repayment as per U.K. law. • The UK legal definition of a deposit is: “a sum of money paid on terms under which it will be repaid either on demand or in circumstances agreed by the parties". In other words, money placed on deposit must be capital certain. • However with a savings account there is a potential conflict between U.K. law, which requires capital certainty, and Shari’ah law, which requires the customer to accept the risk of a loss in order to have the possibility of a return.

22. With the State Bank of Pakistan, legislation has evolved that required a number of amendments to existing laws. With the introduction of interest-free banking in Pakistan from 1st January 1981 amendments were made in the Banking Companies Ordinance 1962, which took effect from 24th December 1980, and

23. included new definitions of “creditor” and “debtor” to make room for new modes of receiving deposits or extending financial accommodation. Also a new section 26A was added, which authorized the banks in Pakistan to accept deposits. • On participation in profit and loss of the bank. • Free of interest or return in any form.

24. Thus in Pakistan, the bank evolved from full financial intermediation, into an IFI that is engaged in participatory intermediation

25. However, the business model of the bank, as indeed reflected in Malaysian legislation, is still required to reserve a percentage of liquid assets, as referred to in Art.16 of the IBA (1983) and Art.38 in BAFIA (1989), which refers to statutory reserves required as per the Central Bank of Malaysia Act (1958); this ratio is the deposit multiplier inherent in fractional reserve banking and thus, the basic function of a bank is dealing with the commoditization, manufacture and provision of money at a profit for the benefit of it’s shareholders, and like any other company, it is in the business of profit maximization.

26. Under the IBA 1983, Islamic banks must set up Shari’ah Advisory Boards (SAB), and ultimately have to comply with the national Shari’ah Advisory Council (SAC). Originally, the bank must set up a Shari’ah advisory body (SAB). • In the articles of association of the bank concerned, provision for the establishment of a Syariah advisory body, as may be approved by the Central Bank, to advise the bank on the operations of its banking business in order to ensure that they do not involve any element which is not approved by the Religion of Islam. Shariah Council

27. Thus the SAB would ensure banking operations conformed to Islam in Art. 3(5) b, but the IBA was amended with effect from 1.1.2004, so that the SAB would have to comply with the SAC upon seeking its advice. • An Islamic bank may seek the advice of the Syariah Advisory Council on Syariah matters relating to its banking business and the Islamic bank shall comply with the advice of the Syariah Advisory Council.

28. The Anti-Money Laundering and Anti-Terrorism Financing Act (AMLA) was enacted in July 2001, and came into force on 15th January 2002. • It involves financial intelligence, reporting and investigation that may require suppression, freezing and seizure of assets (including bank accounts) of those engaged in money laundering and terrorism. Anti-Money Laundering and Anti-Terrorism Financing Act

29. The Financial Intelligence Unit (FIU) was established on 8th August 2002 within Bank Negara to perform the functions of AMLA. • The act provides for the FIU to collaborate with any domestic regulatory, supervisory and enforcement agencies in intelligence gathering, analysis and dissemination.

30. The national money laundering programme emphasizes on the funding of terrorists and thus deemed to be abetting terrorism and liable for prosecution under the Penal Code. Those receiving funds also commit money-laundering offences from dealing with proceeds from illegal activities.

31. Banks typically should appoint a compliance-officer, to monitor and supervise all obligations required under AMLA, including liaising with BNM and the FIU. • Under AMLA activities are monitored in that any transactions above RM 50,000 have to be reported to BNM.

32. BNM has issued guidelines (BNM/GP9) on money laundering and “Know Your Customer Policy” with references to AMLA (2001). • Money laundering itself is changing the identity of illegally obtained money into a legitimate source. The key stage for the detection of money laundering operations is where cash first enters the banking system in the form of cash deposits.

33. There are three stages in the money laundering Process:- 1. The placement stage Whereby proceeds of illegal activities are placed in a deposit account and purchase travelers cheques, bankers cheques or demand drafts.

34. 2. The layering stage Involves changing the structure of the funds, and moving these funds from one bank to another in order to conceal the source of ownership through telegraphic transfer – this separates the illicit proceeds from their source by creating complex layers of financial transactions designed to disguise the audit trail and provide anonymity. 3. Integration stage involves the funds re-entering the financial system through the purchase of bonds, shares and other investments, and thus turning the criminally derived wealth into legitimate funds.

35. BNM as with other central banks have adopted the Basel Committee on Banking Regulations and Supervisory Practices’ “Know Your Customer Policy.” • Customer identification – the bank must take the effort to identify the customer when opening an account or performing any other service.

36. Compliance with legislation and law enforcement agencies – the bank must comply with all laws, co-operate with enforcement authorities without breaching customer confidentiality. Record keeping and system – the bank must maintain proper record keeping and test for compliance. • Staff training – the bank must conduct on-going education in procedures in order to recognize and report money laundering.

37. Accordingly, banks should set up policies, procedures and controls to combat money laundering including; a statement of policies, communicated to management and staff, relating to money laundering which incorporates current legislation

38. With regard to moving funds internationally by telegraphic transfer as may be typically required involving any illegal activities, this is typically conducted via SWIFT, and post 9/11 some intelligence services have now developed programmes that can trace the transactional history of movements of funds involving any individual/institution using SWIFT services.

39. An Islamic bank is a company whose main objective is to earn profits. Profit is the difference between revenues and costs. • To generate revenues, an Islamic bank sells Shariah compliant financial products. • To do so, the bank must first acquire deposits. Islamic Banking Operations

40. All the above is only possible when the bank is awarded a banking license by the monetary authority. • To qualify for a license, the bank amongst others must put up a minimum required capital to support the deposit it acquires from the public.

41. It must have a sound business plan and credible group of individuals to run the business. • An Islamic bank is usually set up as a joint-stock company. • To raise capital, the bank the company issues shares for sale to the public.

42. The bank’s management team who devise business strategies usually consists of the principle officers such as the chief executive officer (CEO), the chief financial officer (CFO) and the heads of the retail, corporate and risk management departments to name a few.

43. Banks must be supervised and regulated since they are using public’s money to generate earnings for the shareholders. • Negligence as well as taking excessive risk will lead to high bad debts and erodes deposits.

44. The shareholders are entitled to the bank’s net profit. They are liable to losses up to face value of their shareholdings. The limited liability principle still holds for Islamic banking. •  In conventional banking, deposits are mobilized via the contract of debt. • It is a business that purely relies on leverage.

45. For this reason, the banking business is highly regulated as depositors’ money must be protected from depletion. When banks suffer from high bad debts, failure to honor deposit withdrawals will result in bank runs and consequently credit squeeze and financial chaos.

46. Thus the deposit market is based on lending and borrowing on interest. • In an Islamic bank, deposits are not mobilized via the contract of debt with interest as this is tantamount to riba • Instead, deposits are mobilized through safe-keeping (wadiah yad dhamanah) and partnership (mudarabah) contracts.

47. A wadiah dhamanah deposit is in essence a transaction deposit that gives no contractual returns. • However, there is capital protection on the principle deposit.

48. A mudarabah deposit is an investment deposit, thus it runs on the principle of “al-ghurm bil ghonm”meaning that “ with profit comes risk”…no risks no gain. • Accordingly, no capital protection is awarded to the mudarabah investment while returns are based on performance.

49. These contracts are in turn driven by the 3 principles of trading, namely • 1) the principle of risk-taking (ghorm) • 2) the principle of work and effort (kasb) and • 3) the principle of liability (daman).

50. Based on the Islamic bank’s simple balance sheet and profit-loss statement it is now well understood that the gross profit generated by an Islamic bank is based on the principle of trading (al-bay’).