IRTI Working Paper Series WP# 1435-13

Measuring the Value of Islamic Banks Abdul Ghafar Ismail, Sjaiful Akbar, Siti Manisah Ngalim

3 Ramadan 1435H | June 30, 2014

Islam2c Economics and Finance Research Division

IRTI Working Paper 1435-13 Title: Measuring the Value of Islamic Banks Author(s): Abdul Ghafar Ismail, Sjaiful Akbar, Siti Manisah Ngalim

Abstract

This study tries to measure the effect of risk sharing in adding value to Islamic banks. In particular, this study is important to accurately gauging the impact of Islamic banking sector on the real economy. The adoption of risk sharing modes of contracts by Islamic bank as intermediary would leads to the fairness in serving the interest of community as a whole and is expected to promote value creation to the depositors, shareholders and eventually to the economy. In analysing the value added or wealth created by Islamic banks, we will use the Annual Reports of Islamic banks in Malaysia from 2008-2012. Our analysis will focus on main hypothesis, i.e., risk sharing create more value added and equitable distribution of wealth. Our finding shows that the adoption of risk sharing would lead to the fairness in serving the interest of community as a whole and is expected to promote value creation to the depositors, shareholders and eventually to the economy. The treatment on non-performing financing and investment risk allowance might change the distribution of wealth. Financial reporting based on contract might produce a more transparent distribution of wealth. Keywords: risk sharing, Islamic banks; value added, wealth distribution, economic

development JEL Classification: D30, E01, G02, G21, 047,

IRTI Working Paper Series has been created to quickly disseminate the findings of the work in progress and share ideas on the issues related to theoretical and practical development of Islamic economics and finance so as to encourage exchange of thoughts. The presentations of papers in this series may not be fully polished. The papers carry the names of the authors and should be accordingly cited. The views expressed in these papers are those of the authors and do not necessarily reflect the views of the Islamic Research and Training Institute or the Islamic Development Bank or those of the members of its Board of Executive Directors or its member countries.

Islamic Research and Training Institute P.O. Box 9201, Jeddah 21413, Kingdom of Saudi Arabia

Measuring the Value Added of Islamic Banks Abdul Ghafar Ismail1 Islamic Research and Training Institute Islamic Development Microfinance institution P.O. Box 9201, Jeddah 21413 Kingdom of Saudi Arabia e-mail:[email protected] Sjaiful Akbar2

Research Center for Islamic Economics and Finance School of Accounting Universiti Kebangsaan Malaysia 43600, Bangi, Selangor, Malaysia [email protected] Siti Manisah Ngalim3 Department of Accounting and Finance Universiti Putra Malaysia Serdang

Malaysia

1.

Introduction

A significant development and rapid expanding trend of Islamic banking in the present century can be witnessed in the Muslim countries as well as major western countries such as United Kingdom, Australia, and Hong Kong. At the outset, the crux of Islamic banking departure from conventional banking systems is the prohibition of Riba, in which the orthodoxy equates with interest in general term while promoting risk sharing as a viable alternative for Islamic bank to operate as intermediary. Leaving itself from interest as its central allocation tool, Islamic bank has developed an impressive range of modes of transactions which primarily based on risk sharing that could appeal to different types of customers. These include two major modes of contracts, namely mudharabah and musharakah that is desirable in an Islamic context due to the characteristics on fair sharing of profit/loss and risk between contracting parties. By offering these modes of contracts, as highlighted by Nik Hassan et.al. (2004) and Ismail (2010), Islamic banking system should seek for social economic justice in order to create an environment that promotes cooperation among society. The adoption of risk sharing modes of contracts by Islamic bank as intermediary would leads to the fairness 1

He is head of research division and Professor of Banking and Financial Economics. He is currently on leave from School of Economics, Universiti Kebangsaan Malaysia. He is also principal research fellow, Institut Islam Hadhari, Universiti Kebangsaan Malaysia and AmBank Group Resident Fellow for Perdana Leadership Foundation. 2 Post-graduate student 3 Lecturer of Islamic accounting * Paper has been presented at 1st International Conference on Islamic Banking and Finance, 17th – 19th April, 2014, Bayero University, Kano-Nigeria

in serving the interest of community as a whole and is expected to promote value creation to the depositors, shareholders and eventually to the economy. Unlike risk sharing, instruments that are interest-based are prone to favour the rich people and against the interests of the common people. For example, when entrepreneurs borrow huge amounts of money from the bank, they are utilizing depositors share into their profitable project. However, when they earn profit, they will pay nothing to the depositors. In the event of losses, it may lead to the bankruptcy of the bank itself and ultimately depositors will have to bear the whole loss. This is how interest-based systems create inequity and imbalance in the distribution of wealth to the economy. Generally, in risk sharing, both depositors and entrepreneur would be willing to share the results of the project in an equitable manner. In the case of profit, both will share in pre-agreed ratios and in the case of loss, all financial loss will be borne by the capital provider (Islamic bank) and labour losses is borne by the entrepreneur. This would build a link between both parties that have business skills but lack of capital and capital provider. The beauty of risk sharing attributes as modes of contract, could facilitate the role of Islamic banks in providing or channelling funds to the skilled entrepreneur in an effort to encourage economic growth. According to Matthews, Tlemsani and Siddiqui (2004), the Islamic economic principles of risk sharing as well as joint involvement in the wealth creation activity through equity financing by investors and entrepreneurs has a potential to entice creativity and productivity in an economy. In addition, risk sharing contracts might drive fairness and subsequently create value for each contracting parties involved. However, experiences (Abalkhail and Presley, 2000; Ahmed, 2002, Tohirin and Ismail (2011)) show that there are some inherent problems (asymmetric information, moral hazard and adverse selection) that might hinders the application of risk sharing. Despite of that, Al-Jarhi (1999) proposes that Islamic banking needs to have an equilibrium combination between mark-up modes and profit-sharing modes of financing. Based on the above studies, it is understood that the adoption of risk sharing contracts might lead to value creation to the shareholders, customers and economy as a whole. Besides that, it drives the Islamic banking system to the different platform that would create balance between the material and social objectives in an effort to provide fairness and justice. Therefore, the success of the application of risk sharing modes in Islamic banking systems will depend heavily on the resolution of the imperfections associated with their use. However, the studies on the effect of risk sharing in adding value to Islamic banks are none. This study is important to accurately gauging the impact of Islamic financial sector on the real economy essential for further work in this area. This article is structured as follows - Section 2 provides an insight into the relationship between finance and economy, in Section 3 the conventional measure of value added is outlined in terms of the current international statistical framework for the financial sector and subsectors; the general issues surrounding the appropriateness of national statistical conventions for measuring of financial sector activity, and specifically banks, are explored in Section 4; and Section 5 concludes.

2.

An Insight into the Relationship between Finance and Economy

Analysing the earlier literature on finance and development theory, as proposed by Schumpeter (1912) and summarised by Ebner (2000), Schumpeter said that “…the process of economic development by combining the exploration of entrepreneurship

and innovation as internal mechanism of change with the cyclical fluctuations that shape the contours of the development process.” In short, he analysed the association between extra cash or capital and the process of economic development through the exploration of entrepreneurship and innovation as the internal mechanism of change. In this, entrepreneurs aims at generating profit, where profit is not the end in itself but a means towards a greater end that includes creating family-dynasty or empire as well as gaining power, authority and control. As the excess cash becomes financial institutions, entrepreneurs become companies but the motivation remains. Since, then, the focus has been on the direction between finance and economic development. Development has always been portrayed as an increase in income and wealth or GDP. Nevertheless, it is worth to mention the conclusion made by Lawrence (2003). He surveyed research on this relationship and concluded from a total of 24 researches done between 1995 and 2003, that there is evidence for causation between growth and finance, specifically from growth to finance and for bi-directionality. He suggests that the data gathered from the survey suggested that financial development thrives where real economy activity is strong. However, some earlier literatures (see Levine (2004)) could not agree with one direction of the relationship by looking into both theoretical and empirical work. He first identified that the problem within the empirical works frequently sourced from insufficient precise link between theory and measures. He then analyses researches covering cross-country research, different type of studies (panel, time-series and casestudies), industry and firm level, bank- or market-based system and reported evidences of a strong positive link between the functions of the financial system and long-run economic growth. He concluded that advancement on this area of research should from now on be on development of a better model that could capture the dynamic of the interaction between the evolution of financial system and economic growth. More importantly, as if drawing the attention back to Schumpeterian theory of finance and growth that looks into the relationship between entrepreneurs and access of capital, he highlights a more relevant but related issue that is the role of finance in alleviating poverty and income inequality. Specifically Levine (2004) highlights the work of Beck, Demirguc-Kunt and Levine (2004), who made the first attempt in examining whether financial development exerts a large influence on the poor (rather than the relationship between financial development and the level of income inequality or level of poverty). They analysed the relationship between financial development and income distribution, and relationship between financial development and alleviation of poverty, from data taken from 52 developed economies and 58 developing countries, respectively. They find income of the poor grows faster than average GDP per capita, income inequality fall more rapidly and poverty rates decrease at a faster rate, all induced by greater financial development. Therefore, financial development has empirically reduces poverty by having a positive effect on the poor. Demirguc-Kunt and Levine (2008) find evidence that financial development boost the income growth of the lowest income quintile. Particularly, they found that expanding individual economic opportunity create positive incentive effects, thus financial development boost efficiency and equity of opportunity. Demirguc-Kunt and Levine (2009) further analyse the relationship between finance and inequality, discussing the theory and finding evidences. They pointed out that in theory, financial developments reduce inequality of opportunity and enhance aggregate efficiency. Particularly, financial developments that lower fixed costs of accessing financial services benefit low-income earners to pay for education and health care thus reduce

inequality of opportunity. In addition, financial developments that operate on a broad margin could facilitate entrepreneurs who have little to offer as collateral thus enhances aggregate efficiency. Further financial development provides greater access to risk management and insurance services that directly improve welfare and allow families to continuously educate their children. More importantly, financial development that increases economic activity will stimulate the demand for labour; enhance earnings and provide a richer range of economic opportunities. In this, Demirguc-Kunt and Levine (2009) highlighted the need for additional research on finance and economic opportunity. Although inconclusive, these theories are supported by empirical evidences and clearly promote economic growth. Consequently, they called for assessment of financial sector policies that affect economic opportunity and poverty. In relation to this, another group of research looks into the access of financial services, as it is a fact that having access to financial services, especially by having a bank account, is the first step towards gaining financial assistance for both households and firms (Ramji 2009). It is an important channel for finance to promote growth through provision of credit to the most promising firms (Beck, Dmirguc-Kunt and Honohan 2009). However, Ghalib and Hailu (2008) reported that the level of access to financial services, especially in developing countries, is low and that for rural population, they lack free and unconstrained access to and use of such services. The access, again specifically in developing countries, often skewed toward those who are not in dire needs of finance such as large enterprises and wealthier individuals while those who are really in needs of financial assistance lack access to finance, hindering their growth and reducing personal welfare (Beck, Demirguc-Kunt and Maksimovic 2005, Claessens 2006, Sarma and Pais 2008). At the same time evidences suggest that in entirety, financial development or depth is both pro-growth as well as pro-poor (Beck et al. 2009), where greater access will make both firms and households able to take advantage of investment opportunities, smooth consumption and insure themselves (World Bank 2008). In a report by World Bank (2008), making financial services available to all potential customers without discrimination spreads equal opportunity and taps the full potential in an economy. This financial inclusion is crucial in order to avert poor individuals and small firms from relying on their personal wealth or internal resources as such reliance could limit their opportunities to invest in their education, become entrepreneurs or take advantage of promising growth. It points out the fundamental trade-off between growth and social justice. This is true since rapid growth need wealth concentration to finance large and indivisible investment projects while it is a fact that the rich tend to save compared to the poor. In other words, there should exist a redistribution of wealth in the economy from the rich to the poor, a principle that is crucial under Islamic economics. The vast research on finance and income inequality and poverty alleviation, demonstrate how important it is to look beyond the relationship between finance and development as portrayed earlier. It implies that there occur a bigger objective of financial existence and a deeper meaning of development such as alleviating poverty, securing education, insuring health and make equal opportunity available for all entrepreneurs without losing focus on the functions of financial intermediaries in ensuring development of an economy. Regardless of different conclusions from literature reviews on finance and development by Lawrence (2003) and Levine (2004), researchers agreed on the important role that financial system plays. Islamic banking by function is no different than the conventional banking. Kahf (2007) and Wan-Ibrahim and Ismail (2014) make a very clear and direct comparison

between Islamic banking and conventional banking. Financial intermediaries is the major function of the conventional banking system, where they receive funds from depositors/savers and reallocate those funds to borrowers/entrepreneurs who need the funds for their economic transactions and activities. Islamic banks, also as an intermediary, are doing exactly the same. Similarly, financing in general is the provision of factors of production, means of payments of goods and services without requiring an immediate counterpart to be paid by the receiver. It is equal to what offered by Islamic financing, which provides factors of production, goods and services for which payment is deferred. Nevertheless, Islamic banking does not involve lending and borrowing because interest, is prohibited by the guiding law, the Sharia (Algaoud and Lewis 2007). Instead it relies on three principles that involve sharing of the actual, reallife outcomes of production process, namely sharing, leasing and sale (Kahf 2007 and Wan-Kamarudin and Ismail (2013)). Reliance on these contracts is what makes Islamic banking a more active stimulant of growth in an economy as compared to conventional banking. Khan (1987) illustrated the economic effect of substituting interest with Islamic financing and found that essentially the same market forces are operative and profitshares instead of interest equilibrate the market loanable funds. Given an adequate supply of loanable funds, under Islamic financing two direct effects will take place. First, investment maybe higher since entrepreneur can pass part of the uncertainty of the production to the financiers and no competing financial assets diverting funds from real investments. Second, the ability to pass part of risk to financier will encourage composition of investment towards more risky and reduce cost pressure for business efficiency which fixed interest rate imposed. At the same time it may also lower cost of production and encourage output, whereas specification of a profit-share will not affect the price output decision. Hence, the risk sharing based financing musharaka is the preferred Islamic mode of financing because it adheres most closely to the principle of profit and loss sharing (Mirakhor and Zaidi 2007, and Ismail and Tohirin (2009)). Comparing profitsharing (mudaraba) with interest-taking (conventional loan) Uthman (2006) found that workers’ share of profit has a positive impact upon the national profit rate and share. This condition implies that profit-sharing is more conducive to investment, capital accumulation and hence job creation than the interest-based system, which is in line with the Islamic economics aim to redistribute wealth and social justice, maintaining a balance with individual interests (Khan 2008). Also, financing modes that depend on profit and loss sharing bring important advantage since they have almost same effect of direct investment, which brings pronounce returns to economic development (Al-Jarhi and Iqbal 2001).

3.

Measuring Value Added from Islamic Bank’s Balance Sheet

Theoretically, GDP can be viewed in three different ways: The production approach sums the “value-added” at each stage of production, where value-added is defined as total sales less the value of intermediate inputs into the production process. For example, flour would be an intermediate input and bread the final product; or an architect’s services would be an intermediate input and the building the final product. The expenditure approach adds up the value of purchases made by final users for example, the consumption of food, televisions, and medical services by households; the investments in machinery by companies; and the purchases of goods and services

by the government and foreigners. Gross savings are calculated as the difference between GNI (Gross National Income) and public and private consumption plus net current transfers. GNI and GNI per capita are the sum of gross value added by all resident producers plus any product taxes (less subsidies) that are not included in the valuation of output plus net receipts of primary income (compensation of employees and property income) from abroad. To smooth fluctuations in prices and exchange rates, World Bank uses a special Atlas method of conversion.4 This is relatively difficult for an individual financial firm such as Islamic bank. Hence, the income approach is much more reliable. The income approach sums the incomes generated by production - for example, the compensation employees receive and the operating surplus of companies (roughly sales less costs). For financial firm, like Islamic bank, the approach to measuring value added has never been touched before. Firstly, the expenditure approach does not appropriately capture the full balance sheet composition of the Islamic banks as shown by the example in Table 1. It only captures the liabilities of Islamic banks.

4

This applies a conversion factor that averages the exchange rate for a given year and the two preceding years, adjusted for differences in rates of inflation between the country and the G-5 countries. Per capita is GNI divided by the midyear population?

Table 1: Calculating Wealth from Islamic Banks’s Balance Sheet

In thousand Ringgit Malaysia

Assets Cash

2009

2010

2011

2012

44,444,333.00

40,022,812.00

55,809,442.00

43,051,750.00

Financing

107,660,630.00

135,185,530.00

188,188,118.00

233,254,753.00

Investment

18,817,183.00

27,154,411.00

25,151,949.00

35,087,066.00

Other Assets

13,641,942.00

16,415,786.00

23,316,069.00

34,514,385.00

Total Asset

184,564,088.00

218,778,539.00

292,465,578.00

345,907,954.00

Deposits

67,901,030.00

80,444,219.00

120,267,641.00

160,819,161.00

Investment

92,009,721.00

110,254,031.00

139,155,854.00

140,808,583.00

12,481,960.00

12,345,937.00

14,827,676.00

23,159,234.00

Equity

12,171,377.00

15,734,352.00

18,214,407.00

21,120,976.00

Total Liabilities Equity

184,564,088.00

218,778,539.00

292,465,578.00

345,907,954.00

Equity and Liabilities

Other Liabilities

Secondly, Islamic banks’ output omits other features such as capital gains and losses, impaired financings, capital injections and promissory notes. Value added measures a sector’s output based on production (or transactions) in a given time period. During each period net income and expense flows accumulate in a profit or loss which is then carried forward to the balance sheet. Profits in the years preceding the recession, contributed positively to value added and the balance sheet position of the sector. The losses on Islamic banks’ assets which materialised subsequently are not, however, treated as negative output in national accounts, as they are not part of production. Instead, they are only reflected as a reduction in the sectorial balance sheet. This leads to an asymmetry in the treatment of profits and of holding gains/losses in national accounts, particularly in the measurement of value added.

As an example, let say, both Islamic banks (A and B) seek to maximise profits, and have financing books worth RM100 on the asset side of their balance sheets. Bank A operates a simplified balance sheet and funds its financing book mainly through its deposit base of RM80. It charges mark-up rate 3 per cent for financing and pays a hiba rate of 1% on deposits. Bank B raises funds mainly in the wholesale funding market and uses the proceeds onward to entrepreneurs. It receives 3 per cent mark-up rate on financing and pays 1 per cent on both deposits and sukuk. An interbank mudarabah rate of 2 per cent prevails. Table 2: Calculating Value Added from Islamic Banks’s Profit and Loss

In thousand Ringgit Malaysia 2009 Panel A: Income derived from investment of depositors’ funds & others     

Financing income & hibah Other dealing income Other operating income Fee & commissi on Other income

(-) Allowance for losses on financing

2010

2011

2012

9,837,222.00

10,222,763.0 0

14,231,437.0 0

7,215,123.00

9,492,007.00

9,564,415.00

13,411,036.0 0

75,724.00

70,644.00

78,701.00

121,311.00

44,771.00

64,278.00

388,848.00

329,081.00

192,698.00

206,358.00

185,306.00

362,579.00

1,431.00

3,935.00

5,493.00

7,430.00

(780,616.00)

(669,568.00)

7,529,747.00

(1,139,409.00)

(1,275,674.00)

(-) Provision for commitments & contingencies

(10,978.00)

12,795.00

(54,375.00)

(17,640.00)

(-) Impairment loss from dealing & investment securities (investment risk reserves)

(26,256.00)

(75,089.00)

48,397.00

14,207.00

83,571.00

10,929.00

(46,771.00)

(122,421.00)

(-) Transfer to/(from) profit equalization reserve (-) Other expenses directly attributable to the investment of the

32,896.00 133,746.00

(54,957.00)

(103,401.00)

depositors and shareholders’ funds

Panel B: Total distributable income

(-) Income attributable to the depositors    

  

Deposits from customers Mudaraba h Fund NonMudaraba h Fund Deposits & placement s of banks & other financial institution s Mudaraba h Fund NonMudaraba h Fund Others

Panel C: Income attributable to the shareholders

( + ) Income derived from the investment of shareholders’/Isla mic Banking funds   

Financing income & hibah Other dealing income Other operating income

6,331,043.00

8,529,599.00

9,472,969.00

13,446,944.0 0

(3,222,239.00)

(3,917,055.00)

(4,784,190.00)

(7,173,697.00)

2,282,209.00

2,886,315.00

3,633,550.00

5,617,253.00

2,106,397.00

2,534,424.00

3,085,169.00

779,918.00

1,099,126.00

2,532,084.00

1,030,740.00

1,150,640.00

1,556,444.00

74,216.00

48,291.00

42,501.00

155,608.00

3,108,804.00

4,612,544.00

4,688,779.00

6,273,247.00

1,128,414.00

1,349,314.00

1,275,696.00

1,708,353.00

693,999.00

900,707.00

834,191.00

1,073,154.00

29,091.00

21,704.00

29,088.00

74,708.00

146,038.00

95,254.00

61,312.00

105,626.00

1,667,507.00

614,702.00 940,030.00



Fee & commissi on  Other income Panel D: Total net income

( - ) Personnel expenses ( - ) Other overheads & expenditures (-) Amortisation of intangible assets (-) Impairment loss from property, plant & equipment and other assets

241,093.00

318,256.00

341,176.00

436,231.00

18,193.00

13,393.00

9,929.00

146,038.00

4,237,218.00

5,961,858.00

5,964,475.00

7,981,600.00

(625,323.00)

(947,427.00)

(862,144.00)

(1,006,381.0 0)

(1,572,978.0 0)

(1,983,763.0 0)

(1,891,204.0 0)

(2,649,186.0 0)

(7,309.00)

(11,131.00)

(2,434.00)

(4,194.00)

-

(18.00)

-

-

(37,580.00)

(39,631.00)

(70,184.00)

(117,755.00)

1,994,028.00

2,979,888.00

3,138,509.00

4,204,084.00

(22,755.00)

(27,479.00)

(28,772.00)

(36,305.00)

(503,001.00)

(703,500.00)

(770,840.00)

(1,053,530.00)

1,468,272.00

2,248,909.00

2,338,897.00

3,114,249.00

-

-

-

-

1,468,272.00

2,248,909.00

2,338,897.00

3,114,249.00

-

(51.00)

(1,325.00)

1,732.00

( - ) Finance cost

Panel E: Profit before zakat & taxation

(-) Zakat (-) Taxation

Panel F: Profit after zakat & taxation

(-) Extraordinary item

Panel G: Profit after the extraordinary item

(-) Minority interest

Panel H: Net profit for the financial year

1,468,272.00

2,248,858.00

2,337,572.00

3,115,981.00

The statistical framework treats the operating surplus of these two banks differently. Firstly, the calculation of banks’ operating surplus is confined to their financing and deposit portfolio and is not fully representative of their entire balance sheet. Bank A’s profits of RM1.80, comprise financing book related profits of RM1 = [RM100*(0.03 - 0.02)], and profits from its deposit book of RM0.80 = [80*(0.02 - 0.01)]. The total profits related to Bank B’s financing and deposits, are lower, amounting to RM1.20, comprising financing profits of RM1 = [RM100*(0.03 - 0.02)] and deposit profits of RM0.20 = [20*(0.02 - 0.01)]. The sukuk issuance in the wholesale funding market by Bank B of RM70 is ignored as are its equity assets. Basically, Islamic banks process payments and other transactions for customers and nonfinancial companies, screening and monitoring projects, as well as underwriting a variety of sukuk. The value of such services (Panel A, Table 2), net of items such as allowance for losses on financing and provision for commitments and contingencies, gives us the Islamic bank industry’s value added (Panel B, Table 2), which is the industry’s direct contribution to GDP. Although, it is difficult to measure the RM amount (let alone the inflation-adjusted real value) of Islamic banks’ value added. This is primarily because they often do not charge explicitly for services. Instead, they earn a spread between the mark-up received and the hibah rates paid (income attributable to depositors), as well as fees for writing sukuk products. But earning spread is not in and of itself a productive activity that contributes to GDP. This is obviously sensible in the case of passive investors who buy market sukuk (in the secondary market) and then merely receive return or dividends without producing new goods or services. In reality, Islamic banks are not mere passive investors. They do hire workers (see Panel C) and equipment, and also buy and sell commodities to carry out various services. When the compensation for such services is not earned explicitly but bundled with asset returns that arise purely because of risk differentials, the question becomes how to tease out that portion of an Islamic bank’s overall income that is implicit revenue for services. The net income of an Islamic bank after these adjustments is a correct measure of its contribution to economic output. Islamic bank, functioning as the intermediaries between sources of funds and users of funds, could offer services that would give opportunity to create employment (by spending on personnel expenses and other overhead and expenditures (Panel D, Table 2), thus assist in fulfilling the removal of poverty and need fulfilment and also via zakat payment (Panel E). Finally, Islamic banks also create wealth to shareholders (Panels E, F and G). In addition, Islamic banks could also be able to provide the freedom of the people in the sense of free from unnecessary debt, mostly due to spending more than what earned. Banks could assist this notion of freedom by providing the opportunity to save and invest rather than to spend beyond their means, which could be related to the offering of credit card. Education is essential to develop human self, either to develop their intellectuals or to prepare them for employment and selfemployment, which in turn would remove poverty. Though it is not obligated for banks to offer educational financing, offering such financing would give the opportunity for the public to earn higher education. Nevertheless, it is noted that banks might also spend their wealth in offering sponsorship and donation towards education instead of offering financing.

4.

Findings

In analysing the value added or wealth created by Islamic banks, we will use the Annual Reports of Islamic banks in Malaysia from 2009-2012. Our analysis will focus on how much of the income received by Islamic banks is compensated for actual services

provided to their customers and how much is merely for taking on risk, such as funding risky financing with short-term deposits? (a)

Creating Wealth via Risk Sharing

As reported in Table 3, during the financial year to 31 December 2012, Islamic bank created wealth of RM7.9 billion, an increase of 88.1% on the wealth created during the 2009 financial year. While much of wealth generation benefits the employees, shareholders, customers, suppliers and government treasuries, Islamic banks remain focused on contributing to the socioeconomic development of the communities. Islamic banks recognize and accepts the responsibility to contribute (via zakah) to the broader socioeconomic goals of poverty relief, improved health, better education and general social development especially in poor communities. Such bank-led initiatives encourage economic development, strengthen civil society and promote the development and building of a democracy. The benefits of Islamic banks involvement include transferring technology, expanding financial services and providing capital in the countries in which Islamic banks operate. These benefits support growth and development. The primary challenge for Islamic banks is to operate successfully in an increasingly globalised environment. At the same time, business is required to go beyond narrow financial considerations and to balance the social, environmental and economic demands of its stakeholders. Islamic banks contribution to the economies in which it operates should be seen in this context. Value-added wealth is the wealth created by Islamic banks through the provision of banking and other financial services. The Islamic banks’ returns in fee-based income has been included in profit, commission and other revenues. Islamic banks once again met their primary financial objectives of strong value-added growth. This increased from RM4.2 billion in 2009 to RM7.9 billion in 2012. As a result, the distribution of wealth to employees, government and shareholders increased from RM62503 million, RM503.0 million, and RM349.6 million in 2009 to RM1.0 billion, RM1.1 billion and RM1.1 billion in 2012, respectively. At the same time, the retained earnings also increased from RM1.1 billion in 2009 to RM3.2 billion in 2012. The figures above show a significant contribution by Islamic banks to the economy during the period of 2009-2012. On the average, as shown in Diagram 1, the employees, government, shareholders (all are economic agents) and retentions received about 12.6%, 13.2%, 14.0% and 40.1%, respectively of the total wealth.

Table 3:

Financial Summary of Islamic Banks In thousands Ringgit Malaysia

2009

2010

2011

2012

Profit, Commissions and Other revenues

8,658,161.00

11,186,536.00

11,498,459.00

15,939,790.00

Profit paid to depositors and cost of other services

(4,420,943.00)

(5,224,678.00)

(5,533,984.00)

(7,958,190.00)

Value added

Wealth created

4,237,218.00

5,961,858.00

5,964,475.00

7,981,600.00

Salaries and other benefits

(625,323.00)

(947,427.00)

(862,144.00)

(1,006,381.00)

Governments

(503,001.00)

(703,500.00)

(770,840.00)

(1,053,530.00)

(22,755.00)

(27,479.00)

(28,772.00)

(36,305.00)

(349,561.00)

(734,267.00)

(817,721.00)

(1,114,402.00)

-

-

-

-

Retentions to support future business growth

(1,205,816.00)

(1,700,191.00)

(1,978,984.00)

(3,204,223.00)

Retained surplus

(1,127,032.00)

(1,588,974.00)

(1,958,059.00)

(3,174,963.00)

(78,784.00)

(111,217.00)

(20,925.00)

(29,260.00)

Others

(2,706,456.00)

(1,848,994.00)

(1506,014.00)

(6,414,841.00)

Wealth distributed

(4,237,218.00)

(5,961,858.00)

(5,964,475.00)

(7,981,600.00)

Distribution of wealth Employees

Zakat Shareholders Dividends paid to shareholders Earnings attributable to outside and preference shareholders

Depreciation & amortization

Wealth distribution over four years (%)

Employees Government Shareholders Retentions Zakat Others

2009 14.76 11.87 8.25 28.46 0.54 36.13

2010 15.89 11.80 12.32 29.33 0.46 30.19

2011 14.45 12.92 13.71 33.17 0.48 25.25

2012 12.61 13.20 13.96 40.15 0.45 19.63

Graph 1(a): value added and total assets; (for 2009) 400,000

250,000

350,000 300,000 250,000

200,000 150,000

200,000

150,000 100,000

100,000 50,000

50,000 -

Value Added Total Asset

-

Value added in 10,000 RM Total Asset in 100,000 RM

Graph 1(b): value added and total assets; (for 2010) 500,000 450,000 400,000 350,000 300,000 250,000 200,000 150,000 100,000 50,000 -

300,000 250,000 200,000 150,000 100,000 50,000 -

Value Added Total Asset

Value added in 10,000 RM Total Asset in 100,000 RM Graph 1(c): value added and total assets; (for 2012) 1,000,000 900,000 800,000 700,000 600,000 500,000 400,000 300,000 200,000 100,000 -

600,000 500,000 400,000 300,000 200,000 100,000 -

Value Added Total Asset

Value added in 10,000 RM Total Asset in 100,000 RM

Graph 1(d): value added and total assets (for 2009-2012) 13 Islamic Banks in Malaysia 4,000,000

2,500,000

3,500,000 2,000,000

3,000,000 2,500,000

1,500,000 Value Added

2,000,000 1,000,000

1,500,000 1,000,000

Total Asset

500,000

500,000 -

2009

2010

2011

2012

Value added in 10,000 RM Total Asset in 100,000 RM Graph 2(a): y-axis: value added and total financings (for 2009) 300,000 250,000 200,000 150,000 100,000 50,000 -

180,000 160,000 140,000 120,000 100,000 80,000 60,000 40,000

Value Added

20,000

Total Financing

-

Value added in 10,000 RM Total Financing in 100,000 RM

Graph 2(b): value added and total financings (for 2010)

350,000

300,000

250,000 200,000

250,000 200,000

150,000

150,000

100,000

100,000 50,000 -

50,000

Value Added Total Financing

-

Value added in 10,000 RM Total Financing in 100,000 RM Graph 2(c): value added and total financings (for 2012) 700,000 600,000 500,000 400,000 300,000 200,000 100,000 -

450,000 400,000 350,000 300,000 250,000 200,000 150,000 100,000 50,000 -

Value Added Total Financing

Value added in 10,000 RM Total Financing in 100,000 RM

Graph 2(d): value added and total financings (for 2009-2012) 2,500,000

1,800,000 1,600,000

2,000,000

1,400,000 1,200,000

1,500,000

1,000,000 800,000

1,000,000

Value Added Total Financing

600,000 400,000

500,000

200,000 -

2009

2010

2011

2012

Value added in 10,000 RM Total Financing in 100,000 RM Graph 3(a): value added and total deposits (for 2009) 180,000 160,000 140,000 120,000 100,000 80,000 60,000 40,000 20,000 -

140,000 120,000 100,000 80,000 60,000 40,000

20,000 -

Value Added Total Deposit

Value added in 10,000 RM Total Deposit in 100,000 RM

Graph 3(b): value added and total deposits (for 2010) 200,000 180,000 160,000 140,000 120,000 100,000 80,000 60,000 40,000 20,000 -

160,000 140,000 120,000 100,000 80,000 60,000 40,000 20,000 -

Value Added Total Deposit

Value added in 10,000 RM Total Deposit in 100,000 RM

Graph 3(c): value added and total deposits (for 2012)

600,000 500,000

400,000 350,000 300,000

400,000 300,000 200,000

250,000 200,000 150,000 100,000

100,000 -

50,000

Value Added

-

Total Deposit

Value added in 10,000 RM Total Deposit in 100,000 RM

Graph 3(d): value added and total deposits (for 2009-2012) 1,800,000

1,400,000

1,600,000

1,200,000

1,400,000 1,000,000

1,200,000

1,000,000

800,000

800,000

600,000

Value Added

600,000

Total Deposit

400,000

400,000 200,000

200,000 -

2009

2010

2011

2012

Value added in 10,000 RM Total Deposit in 100,000 RM Graph 4(a): histogram: distribution of wealth by each bank (2009)

900000 800000 700000 600000 500000 400000 300000 200000 100000 0

Others Zakat Retentions Shareholders Government Employees

In 1,000 RM

Graph 4(b): histogram: distribution of wealth by each bank (2010) 1600000 1400000 1200000 1000000 800000 600000 400000 200000 0

Others

Zakat Retentions Shareholders Government Employees

In 1,000 RM Graph 4(c): histogram: distribution of wealth by each bank (2012) 2000000 1800000 1600000 1400000 1200000 1000000 800000 600000 400000 200000 0

Others Zakat Retentions Shareholders Government Employees

In 1,000 RM

Benefiting Employees, Customers and Communities

In Islam, wealth should be circulated within and economy in order to ensure equitable distribution of wealth and could also be the source for employment and selfemployment. Therefore, Islamic bank should redistribute its income and wealth back to the economy. There are at least several parties that should be considered in redistributing the wealth as shown in Table 2 and these redistribution are divided into two, obligatory and voluntarily. Islamic bank A, as shown in Table 3, paid the employees RM8.5 billion during 2008. The amount paid in 2007 was RM7.6 billion. A conservative economic estimate indicates that more people directly depend on Islamic bank A for their livelihood. Customers received an amount of RM31.2 billion during 2008. It contributed a substantial amount to their wealth. Furthermore, Islamic bank A contribute to the economy by providing affordable, effective banking and financial services to diverse individuals and organizations; contributing over RM2.9 billion to the government in the form of taxes in 2008; and promoting economic stability and convenience in local communities through extensive branch networks.

5.

Conclusion

The role of Islamic banks includes: to clear and settle payments; to aggregate (pool) and disaggregate wealth and to allow flow of funds so that both large-scale and smallscale projects can be financed; to transfer economic resources over time, location, and sectors; to accumulate, process and disseminate information for decision-making purposes; to provide ways for managing uncertainty and controlling risk; and to provide ways for dealing with risks and return issues that arise in financial contracting. These roles can be performed by offering financial transactions, pooling savings and channeling funds. By performing these roles, Islamic banks play a valuable and integral part in the development of the national economy by creating wealth for individuals and the community. Therefore, there are a number of suggestion for future research: first, the adoption of RISK SHARING modes of financing by Islamic bank as intermediary would leads to the fairness in serving the interest of community as a whole and is expected to promote value creation to the depositors, share holders and eventually to the economy. Could a higher RISK SHARING create a better distribution? Second, regulation such regulation on non-performing financing and investment risk allowance might change the distribution of wealth. Third, financial reporting based on contract might produce a more transparent distribution of wealth. Islamic banks play a valuable and integral part in the development of the national economy. By focusing on sustainable economic wealth, Islamic banks can economically empower employees, shareholders and business partners, and can also contribute to the sustainability of state treasuries and a diverse spectrum of important social development projects. In essence Islamic banks are able to generate employment and to increase the shareholder’s and entrepreneur’s wealth. The economic contribution of Islamic banks can be seen by looking at the following example.

It appears likely that the study states the Islamic banks’ contribution to GDP, and we now have evidence that this is indeed the case. To the extent that risk sharing is one the suggested model for Islamic banking, we have a method for proving the superiority of this method and to arrive at a ‘clear’ evidence of the contribution that Islamic banks

make to GDP. In order to estimate the model’s ability to redistribute wealth, however, we need to go further and analyse their distribution. Better measures of real financial output may overturn the current consensus that the financial industry accounted for a significant portion of the country productivity acceleration over the period 2009 to 2012.

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