Islamic Banking Operations & Instruments

Islamic Banking Foundations

• Shari’ah divides activities into:
  • Ibadah (worship) – 5 pillars (Shahadah, Salat, Zakat, Sawm, Hajj)
  • Mu’amalat (man-to-man dealings) – social, economic & financial activities
• Islamic banking/finance must remain within Shari’ah boundaries → asset-backed, ethical, risk-sharing
• Six Key Principles
  • Prohibition of predetermined interest $\text{(riba)}$
  • Profit & loss sharing (PLS) central to system
  • Money cannot be made from money; transactions must be asset-based
  • Ban on excessive uncertainty/speculation $\text{(gharar)}$
  • Only Shari’ah-approved contracts acceptable
  • Sanctity/enforceability of contracts
• Vatican Quote: Ethical foundations of Islamic finance viewed as stabilising for global banking (Bloomberg 2009)

Global Landscape & Institutional Forms

• Presence on all continents: Dubai Islamic Bank, Abu Dhabi IB, Al Rajhi, Bank Islam Malaysia, HSBC Amanah, Citi, UBS windows, Islamic Bank of Britain, NASDAQ Dubai etc.
• Three institutional models
  • Windows – Islamic products inside conventional bank (low cost, dependent on parent)
  • Subsidiary – separate Islamic entity under conventional parent (medium set-up cost; independent mgmt; Shari’ah governance; need separate treasury & GL)
  • Full-fledged Islamic Bank – stand-alone infrastructure; highest operating cost but full independence

Islamic Accounting Perspective

• Definition: “Accounting process that provides info enabling stakeholders to ensure continuous Shari’ah compliance & socio-economic objectives.”
• Transaction → Book-keeping → Financial statements flow identical to conventional but classification & recognition differ
• Ongoing debate Cash vs Accrual accounting:
  • Cash: recognise profit only when realised → volatile but actual
  • Accrual: recognise expected profit progressively → internationally accepted; smoother

Conceptual Balance Sheet of an Islamic Financial Institution (IFI)

ASSETS (Shari’ah-compliant)

• Sales receivables (Murabaha, Salam, Istisna’)
• Investments in leased assets (Ijarah)
• Real estate investments
• Equity/PLS financings (Musharakah, Mudharabah)
• Statutory deposits
  LIABILITIES / EQUITY
• Shareholders’ funds (paid-up capital & retained earnings)
• Transaction deposits (Current/Savings) – Wadiah/Qard, capital-guaranteed
• Profit-sharing investment accounts $\text{(PSIA)}$
  • Unrestricted (URIA / GIA)
  • Restricted (RIA / SIA)
• Profit Equalisation Reserve (PER) & Investment Risk Reserve (IRR)

Replacement of Conventional Items

• Deposits ⇒ PSIA (risk-sharing, variable return) rather than guaranteed interest deposits
• Loans/advances ⇒ asset-backed receivables & PLS financings

Sources of Funds

1. Capital & Equity
   • Paid-up capital during set-up
   • Retained earnings accumulated
2. Transaction Deposits (risk-free to depositor)
   • Current A/c – Wadiah (guaranteed return of principal, no profit; bank may give $hibah$)
   • Savings A/c – Wadiah (same guarantee, discretionary hibah) or Wakalah (target return pre-agreed)
3. Investment Deposits
   • General Investment Account (GIA/URIA) – Mudharabah unrestricted
   • Specific Investment Account (SIA/RIA) – Mudharabah restricted to mandate
   • Characteristics: higher min, longer tenor, possible capital loss, variable profit
4. Cash Wakaf deposits also possible

Funding Structure Snapshot

• Current, Savings, Term Deposits, Cash Waqf ⇒ money inflows
• URIA / RIA ⇒ investment pools
• Shareholder Funds ⇒ capital buffer

Uses of Funds / Financing Types

Retail

• House financing: Musharakah Mutanaqisah, BBA, Ijarah Muntahia bi Tamlik
• Vehicle financing: Ijarah or BBA
• Personal financing: Commodity Murabaha / Bai ‘Inah / Ujrah
  Corporate & Working Capital
• Murabaha, Ijarah, Istisna’, Salam, Musharakah, Mudharabah
• Revolving facilities: Commodity Murabaha, Wakalah, Kafalah guaranteed
  Trade Finance (see dedicated section)
  Other Retail: Islamic Credit Cards (Bai ‘Inah + Wadiah or Ijarah model)

Profit & Pricing Parameters

• Rate types: fixed, floating, flat, rebate structures, fee-based
• Tenors: 1 m – 30 y (mortgage), 1 – 72 m (vehicles), 1 – 12 m (deposits)
• Return drivers: non-performing financing, rescheduling, economic cycle

Profit Recognition & Distribution Mechanism

• Profit Sharing Ratio (PSR) agreed at contract start
• Monthly accrual allowed; final adjustment when asset performance crystallises
• Illustration – General Investment Account
  • Capital $P = 100{,}000$, tenor $t = 0.5\,\text{yr}$, actual profit $r = 8\%$, PSR $70:30$
  • Capital-provider share $= P \times r \times t \times 70\% = 100{,}000 \times 0.08 \times 0.5 \times 0.7 = 2{,}800$
  • Bank share $= 1{,}200$ (30 %)
• Vision by BNM: each deposit pool tagged to a defined asset pool for direct linkage of realised return

Key Islamic Contracts Glossary (selected quiz terms)

• Al-Wadiah Yad Dhamanah – safekeeping with guarantee
• Al-Mudharabah – PLS trust financing
• Al-Musharakah – equity partnership
• Al-Murabahah – cost-plus sale
• Bai’ Bithaman Ajil (BBA) – deferred-payment sale
• Bai’ al-Dayn – debt trading
• Ijarah / Ijarah Thumma al-Bai’ – lease / lease-then-sale
• Qardhul Hassan – benevolent loan
• Bai’ Salam – advance payment sale
• Bai’ al-Istijrar – supply-on-call sale
• Al-Kafalah – guarantee
• Ar-Rahnu – pawn (collateralised loan)
• Al-Wakalah – agency
• Al-Hiwalah – debt transfer
• As-Sarf – currency exchange
• Al-Ujr – fee/commission
• Al-Hibah – gift

Trade Finance Fundamentals

• Trade = domestic & international movement of goods/services
• Players: importers, exporters, banks, insurers, ECAs, logistics providers
• Instruments continuum (Risk balance):
  • Cash-in-advance (exporter secure) → Letter of Credit → Collection → Open Account (importer secure)
• Corporate vs Trade Finance
  • Corporate: long-term value maximisation via equity/debt
  • Trade: short-term funding of specific goods flows

Conventional Instruments

• LOC, Bankers’ Acceptance, Trust Receipt, Guarantees, Factoring, Forfaiting, Structured Commodity Finance

Islamic Trade Finance Contracts (Asset-Based)

• Murabaha Import Financing
• Wakalah Export Financing
• STF (Structured Trade Finance) via Murabaha/Istisna’ etc.

Islamic Letter of Credit (ILC)

1 Wakalah Model
• Bank acts as agent; importer prepays under Wadiah; no transit interest
2 Murabaha Model
• Importer acts as agent to buy goods → bank sells on deferred basis
• Formula $Selling\;Price = P \left[1 + \frac{r \times t}{36500}\right]$
• Profit $= Selling\;Price - P$

Trust Receipt vs Murabaha

• Conventional TR interest variable; Islamic TR uses fixed Murabaha mark-up

Islamic Accepted Bill (IAB)

• Import/local purchase: Murabaha + Bai Dayn (tradeable bill)
• Export/local sales: create bill, sell to bank under Bai Dayn

Islamic Money Market (IIMM – est. 1994)

Purpose

• Short-term funding & portfolio adjustment; monetary policy transmission
  Core Instruments
• Mudharabah Interbank Investment/Deposit (MII/MID): overnight–12 m; profit based on investee’s 1-yr gross profit; negotiable PSR; principal + profit at maturity
• Wadiah Acceptance: surplus funds placed with BNM; dividend = hibah; liquidity absorption tool
• Government Investment Issue (GII): originally Qard-al-Hasan (1983), now Bai ‘Inah & profit-based; tradable via Bay Dayn; coupon semi-annual
• BNM Monetary Notes-i (BNMN-i): 1–3 yr discount or coupon papers
• Sell & Buy-Back Agreement (SBBA): two sale contracts at different prices
• Cagamas Mudharabah Bonds
• When-Issued (WI) trading – promise permitted
• Islamic Negotiable Instruments of Deposit (INID – Mudharabah) & Negotiable Islamic Debt Certificate (NIDC – BBA)
• Islamic Private Debt Securities (sukuk – BBA, Murabaha, Mudharabah)
• Ar-Rahnu Agreement-i (RA-i) – secured Qard tool for BNM liquidity ops
• Sukuk BNM Ijarah (SBNMI) – sale–leaseback; semi-annual rental; RM400 m inaugural 2006

Islamic Deposit Products

Savings A/c – Wadiah / Wakalah

• Guarantee of principal; hibah discretionary (Wadiah) or agreed return target (Wakalah)
  Current A/c – Wadiah Yad Dhamanah / Qardh Hassan / Mudharabah
• Cheque book, immediate withdrawal; profits belong to bank unless hibah; in Mudharabah version PSR applies
  Investment Accounts (IA)
• General vs Specific (URIA vs RIA) Mudharabah
• Features: pooled, variable profit, potential loss, no guarantee; PSR pre-agreed; PER & IRR buffers
  Islamic Fixed Deposit – Commodity Murabaha/Tawarruq
• Wakalah mandate → bank buys commodity cash → sells to depositor deferred (cost + profit) → upfront profit paid; principal on maturity

Islamic Credit Card

Models in Malaysia
1 Bai ‘Inah + Wadiah (Al Taslif, Bank Islam Card)
• Bank sells asset deferred (sale price = purchase + profit); buys back cash; proceeds placed in Wadiah account as card limit
2 Ijarah-based charge card
Account Structure

• Bai ‘Inah profit cap (e.g. RM3,600) + Wadiah limit (e.g. RM20,000) + Qardh Hassan extra limit
  Key Features
• 100 % Shari’ah compliant; no compounding interest; profit margin fixed upfront; filtered MCC codes (bars, gambling, etc.)
• Supplementary cards, takaful cover, bonus points, early-payment rebate
  Comparison with Conventional
• Interest-free, Shari’ah compliance, early payment rebate, compulsory halal usage; conventional has interest, compounding, no usage filter
• Admin fees & floating profit rates still exist; restructuring requires new sale contract (costly)

Other Islamic Financing Products

House Financing

• Musharakah Mutanaqisah (diminishing partnership: buying out bank’s share + Ijarah rent)
• BBA – bank buys house cash, sells deferred; single-tier or multi-tier profit examples:
  • Single-tier: 20 y, monthly $620$ → $Selling\ Price = 620 \times 240 = 148{,}800$
  • Multi-tier: yrs 1–5 @$444$, yrs 6–20 @$670$ → $Selling\ Price = 444\times60 + 670\times180 = 26{,}640 + 120{,}600 = 147{,}240$
  Vehicle Financing
• Ijarah: financing amount $P = 40{,}000$, $r = 5\%$, $t = 7\ \text{yr}$
  • $Total\ Lease = P + P(r\times t)= 40{,}000 + 40{,}000(0.05\times7)= 40{,}000 + 14{,}000 = 54{,}000$
  • Monthly $= 54{,}000/84 = 642.86$
  Project Financing
• Mudharabah: bank capital, entrepreneur effort; PSR e.g. 40 % bank / 60 % customer; bank bears losses
• Musyarakah: equity partnership; profit per PSR (not necessarily equity); losses per equity ratio; conditions (agency, transfer of shares, Shari’ah-compliant project)
• Istisna’: manufacture/construction to order; bank sells on forward basis; suitable for real-estate/development

Advantages & Disadvantages Comparison

Islamic Finance Pros

• Financial justice (risk shared, no interest burden)
• Ethical asset screening (no alcohol, gambling etc.)
• Prudent investment selection
  Cons
• Admin fees comparable to conventional
• Floating profit rate can rise in high-rate regimes
• Contract alteration requires new Bai ‘Inah sale (time & cost)
  Conventional Pros
• No sectoral restriction; easy refinancing amendments
  Cons
• Interest rate risk with no cap; potential budget stress for borrower

Chapter Recap

• Role of Islamic bank: mobilise funds ethically & allocate to real-economy financing using Shari’ah contracts
• Balance-sheet distinctions: PSIA vs deposits; receivables vs loans; PER/IRR reserves
• Funding sources: current, savings, term, investment deposits; shareholder funds
• Use of funds: retail & corporate financing; working-capital trade finance; credit cards
• Islamic trade instruments: ILC (Wakalah & Murabaha), Islamic Accepted Bill, Trust Receipt, Islamic BG/SBBA, shipping guarantees
• Money-market & capital-market products: MII, GII, BNMN-i, INID, NIDC, sukuk
• Other retail innovations: Islamic credit card, cash Wakaf deposits

Ethical & Practical Implications

• Asset-backed requirement ties finance to real economy, reducing speculative bubbles
• Risk-sharing aligns incentives, yet requires robust governance & transparency
• Shari’ah compliance adds additional audit layer (Shari’ah boards) and documentation burden but builds trust
• Standardisation efforts (AAOIFI, IFSB, ISRA) crucial for global marketability