Abdul Ghafar Ismail Professor of banking and financial economics Universiti Kebangsaan Malaysia
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Contents P a r t I : MONEY AND THE ISLAMIC BANKING SYSTEM CHAPTER 1: AN INTRODUCTION TO MONEY AND THE ISLAMIC BANKING SYSTEM The History of Islamic Banking The Components of the Islamic Banking System The Principles of Money and Islamic Banking Principle 1: Money as Capital Principle 2: Rabbul mal and Mudarib Relationships Principle 3: Risk Sharing Principle 4: Markets Set Prices and Generate Profits Principle 5: Islamic Banking Stability Principle 6: Islamic Banks as Agents for Economic Growth The Organization of This Book Summary Key Terms and Concepts Questions CHAPTER 2:
MONEY AND THE PAYMENT SYSTEM The Islamic Concept of Money Ownership Utilization The Functions of Money The medium of exchange The Store of Value The Payment System Cash Payments Payments by Cheque Giro Payments Plastic Cards Charge Cards Credit Cards Debit Cards Credit Cards How does a credit card work in practice? Credit Card Associations Issuers Acquirers Visa Membership Islamic Credit Card Wholesale Payments System
EFPOST CHIPS Automated Clearing House (ACH) Money Flows in the Economy Base Money Bank Money and Bank Reserves The Transaction Money Supply Summary Key Terms and Concepts Questions CHAPTER 3:
FINANCIAL INSTRUMENTS, FINANCIAL MARKETS, AND ISLAMIC BANKING INSTITUTIONS Linkages between Financial Instruments, Markets, and Institutions Financial Instruments The Creation of Financial Contracts Uses of Financial Instruments Financial Markets The Role of Financial Markets The Structure of Financial Markets Money Market Capital Market Foreign Exchange Market Islamic Banking Institutions The Functions of Islamic Banking Institutions The difference between Islamic Banks and Conventional Banks Business Operations Social and Ethical Responsibilities Summary Key Terms and Concepts Questions
P a r t I I : ISLAMIC BANKING OPERATIONS CHAPTER 4:
INTRODUCTION TO BASIC CONTRACTS IN ISLAMIC BANKING Prohibition of Riba Basic Contracts in Islamic Banking Contract of Profit-Sharing Mudarabah Definition Basis of Mudarabah Types of Mudarabah Terms and Conditions of Mudarabah Contract
Modern Applications of Mudarabah Musharakah Definition Basis of Musharakah Types of Musharakah Terms and Conditions of Musharakah Contracts Modern Applications of Musharakah Contract of Sale Ijarah Definition Basis of Ijarah Types of Ijarah Terms and Conditions of Ijarah Contracts Modern Applications of Ijarah Ju'alah Definition Basis of Ju'alah Terms and Conditions of Ju'alah Contract Modern Applications of Ju'alah Bay'al-Murabahah Definition Basis of Bay' al Murabahah Types of Bay' al-Murabahah Terms and Conditions of Bay' al-Murabahah Contract Modern Applications of Bay' al Murabahah Transactions Bay' Salam Definition Basis of Bay' Salam Types of Bay' Salam Essential Elements of Bay' Salam Contract Modern Applications of Bay' Salam Istisna'a Definition Basis of Istisna'a Terms and Conditions of Istisna'a Contract Modern Applications of Istisna'a Qard ulhasanah Definition Basis of Qard ul Hasanah Terms and Conditions of Qard ul Hasanah Contract Modern Applications of Qard ul Hasanah Bay' Bithaman Ajil Definition Basis of Bay' Bithaman Ajil Essential Elements of Bay' Bithaman Ajil Contract
Modern Applications of Bay' Bithaman Ajil Bay As-Sarf Definition Basis of Bay' As-Sarf Terms and Conditions of Bay' As-Sarf Contract Modern Applications of Bay' As-Sarf Contract of Deposits Al Wadi'ah Definition Basis of al-Wadi'ah Types of Wadi'ah Essential Elements of Wadi'ah Contract Modern Applications of Wadi'ah Contract of Wakalah Wakalah Definition Basis of al-Wakalah Types of al-Wakalah Terms and Conditions of al-Wakalah Contract Modern Applications of al-Wakalah Contract of Gift (Hibah) Definition Basis of Hibah Terms and Conditions of Hibah Contracts Modern Applications of Hibah Contract of Security AI-Kafalah Definition Basis of al-Kafalah Types of al-Kafalah Terms and Conditions of al-Kafalah Contract Modern Applications of al-Kafalah Al-Hawalah Definition Basis of al-Hawalah Types of al-Hawalah Terms and Conditions of al-Hiwalah Contract Modern Applications of al-Hiwalah Al-Rahn Definition Basis of al-Rahn Essential Elements of al-Rahn Contract Modern Applications of al-Rahn Summary Key Terms and Concepts Questions
SOURCES OF FUNDS The Balance Sheet of Islamic banks Components of the Balance Sheet Demand Deposits Wadiah Yad Dhamanah Current Account-i Features Mechanism Hibah Distribution Example of Hibah Rate Mudarabah Current Account-i Features Mechanism Profit Distribution Saving Deposits Wadiah Yad Dhamanah Saving Account-i, Features Mechanism Hibah Distribution Example of Hibah Rate Mudarabah Saving Account-i Features Mechanism Profit Distribution Wakalah Saving Account-i Features Mechanism Investment Deposits General Investment Accounts-i Features Mechanism Profit Distribution Example of Mudarabah GIA Return Special Investment Accounts-i Features Mechanism Profit Rate Determination Example of Indicative Rate of Return Specific Investment Account-i Features Mechanism Profit Distribution Deposit-Structured Accounts Commodity Murabahah Deposits Features Mechanism Return
Example of the Rate of Return on Commodity Investment-Linked Deposits Features Mechanism Returns Inter-bank Placement-i Profit Equalization Reserve Investment Risk Reserve Shareholder Funds Paid-up Capital Reserves Statutory Reserves Financing Loss Reserves Other Capital Accounts The Importance of the Sources of Funds Components Summary Key Terms and Concepts Questions CHAPTER 6:
USES OF FUNDS 125 Cash and Cash Equivalents 126 Vault cash 126 Required reserves 126 Due to other Islamic Banks 127 Sales Receivables 127 Bay'-Bithaman Ajil Financing 128 Features 128 Mechanism 128 Calculation of Profit Margin for Financing Activities 129 Calculation of Interim Profit for Partial Disbursement 131 Working Capital Financing-i 134 Features 134 Mechanism 134 Salam Financing 136 Features 136 Mechanism 136 Leasing-i 137 Features 137 Mechanism 138 Rental Payment 139 Hire Purchase-i 140 Features 140 Mechanism 140 Rental Payment 142 Trade Financing 142 Letter of Credit-i 142
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CHAPTER 7:
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Trust Receipt-i Export Credit Refinancing-i Bank Guarantee-i (BG-i) Shipping Guarantee-i (SG-i) Accepted Bills-i Personal Financing Bay' al-Inah Financing Tawarruq Financing Equity Financing Diminishing Musharakah Property Financing-i Features Mechanism Ijarah Payment Mudarabah Project Financing Features Mechanism Investment in Securities Islamic Inter-bank Cheque Clearing System Inter-bank Acceptance-i Bank Negara Negotiable Notes-i Islamic Negotiable Instruments Sale and Buy Back Agreement Features Mechanism Calculation of Proceeds Government Investment Issues Islamic Treasury Bills Cagamas Mudarabah Bonds Islamic Accepted Bills Imports and local purchases Exports and Local sales Islam Private Debt Securities Islamic Commercial Papers Sukuk Features Mechanism Return Fixed Assets Investment in Subsidiaries The Importance of the Uses of Funds Components Summary Key Terms and Concepts Questions
Total Income Income from Financing and Investment Operating Income Dealing Income Fees and Commissions Expenses Administrative Expenses Personnel Expenses Fixed Asset Expenses Other Expenses Allowances Objectives of Allowances Types of Allowances Measurement of Allowances Reserves Profit Equalization Reserves Investment Risk Reserves Total Distributable Income Net Distributable Income Income Attributable to the Depositors and Shareholders Profit After Zakat and Taxation Zakat Taxation Net Profit Retained Earnings Cash Dividend Islamic Bank Profit Model Summary Key Terms and Concepts Questions
EVALUATING ISLAMIC BANK PERFORMANCE Internal Performance Business Planning Strategic Planning Distribution Channel Technology Personal Development External Performance Market Share Regulatory Compliance Shariah Compliance Public Confidence
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Aligning Internal-External Performance Frameworks with Market Valuations 202 Summary 204 Key Terms and Concepts 205 Questions 205 CHAPTER 9:
ANALYZING ISLAMIC BANK PERFORMANCE WITH FINANCIAL RATIOS 207 Financial Performance Indicators 209 Profitability and Sustainability Indicators 209 Efficiency and Productivity Indicators 210 Portfolio Quality Indicators 211 Growth and Outreach Indicators 212 Financial Structure Indicators 213 Interpreting Performance Indicators - Some Examples 214 Earnings Performance Ratios 215 Net Income to Average Assets 215 Provision for Financing Losses to Average Assets 215 Net Realized Gains or Losses to Average Assets 216 Net Income to Average Assets 217 Assets Quality Ratios 217 Non-current Financings to Total Financings 217 Allowance for Financing and Lease Losses to Non-current Financings 218 Capital Adequacy Ratios 218 Cash Dividends to Net Income 218 Tier 1 Capital to Average Assets 218 The Evaluation of Financial Ratios 219 Summary 222 Key Terms and Concepts 222 Questions 223
1 XX j 1 • Contents Compliance Risk Inventory Risk Risk Profiles in an Islamic Bank Market Risk Profiles Credit Risk Profiles Operational Risk Profiles Liquidity Risk Profiles Equity Investment Risk Profiles Displaced Commercial Risk Profiles Summary Key Terms and Concepts Questions
232 232 232 232 233 234 235 236 237 238 238 239
CHAPTER 11: MANAGING RISK Risk Management Agenda Risk Management Tools Economic Capital Formula Hypothetical Example Expected Loss Conceptual Framework Example Value-at-Risk Estimating VaR Example Stress Testing Definition and Applications Techniques for Stress Testing Example on Macro Test of Islamic Banks Regulatory Risk Sources of Regulatory Risks The Costs and Consequences of Regulation Current Practices to Mitigate Risks Profit Equalization Reserve Variable rates of Returns Profit Risk Securitization Profit Rate Swap Summary Key Terms and Concepts Questions
P a r t V: REGULATORY AND SUPERVISORY ENVIRONMENTS
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CHAPTER 12: REGULATION From Law to Regulation
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Reasons for Regulations Safety and Stability Promoting Competition and Efficiency through a Banking Structure Public Confidence Market Discipline Basis for Monetary Policy Policy Issues Related to Regulations Regulations on Islamic Bank Activities and Banking-Commerce Links Regulations on Domestic and Foreign Islamic Banks Entry Regulations on Capital Adequacy Deposit Insurance Design Regulations on Easing Private Sector Monitoring of Islamic Banks Government Ownership of Islamic Banks Legal Framework The Central Bank Ordinance 1958 Islamic Banking Act 1983 Banking and Financial Institutions Act 1989 Government Investment Act 1983 Regulatory Environtments Guideline on the Shariah Advisory Council Guideline on Corporate Governance Guideline on the Presentation of Financial Statements Guidelines on Rate of Return Guidelines on Total Insured Deposits Guidelines on Islamic Banking Products Accepted Bills-i Sells and Buys Back Agreement Transactions Summary Key Terms and Concepts Questions CHAPTER 13: SUPERVISION The Philosophy The Objectives Risk-based Supervision The Approach The Framework Stage 1: Full Scope Examination of Islamic Banks Stage 2: Impact Assessment of Islamic Banks Stage 3: Risk Assessment of Islamic Banks Stage 4: Development of a Risk Mitigation Programme Stage 5: Evaluation and Validation
Stage 6: Communicating the Results of the Assessment and Risk Mitigation Programme to the Islamic Bank 306 Stage 7: Implementation of Risk Mitigation Programme, On-Going Assessment and Response to Risk Escalation 307 The Supervisory Processes 308 Off-Site Surveillance 308 Pre Conditions for Effective Off-Site Surveillance 308 Off-Site Surveillance Processes 309 On-Site Examination Process 312 Examination Planning 312 Examination Programme 313 Examination Procedures 314 Stress Testing 317 Stress Testing Procedure 317 Stress-Testing Tools 318 Supervisory Concerns 318 Capital Adequacy and Earning Sustainability 318 Continuous Surveillance 319 Monitoring System 319 Risk Management Tools 322 Supervisory and Enforcement Actions 325 Summary 326 Key Terms and Concepts 326 Questions 327
P a r t V I : CAPITAL, LIABILITIES, ASSETS AND OFF-BALANCE SHEET MANAGEMENT
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CHAPTER 14: CAPITAL MANAGEMENT Definition of Islamic Bank Capital Equity Reserves Capital Hybrid Role of Islamic Bank Capital Regulator's View on Capital Adequacy Capital Standards Capital Base Risk-Adjusted Assets Conversion from Off-Balance Sheet Shareholders' Viewpoint on Capital Adequacy Capital Structure Decision Asset Investment Considerations Securitization
Dividend Policy Capital Allocation Fulfilling the Capital Requirements Capital Adequacy Standard Basis for Minimum Capital Adequacy Requirements The Proposed Minimum Capital Requirements Shariah Compliant Instruments Provisions for Operational Risk Adjustment to the Capital Ratio Denominator Innovations in Capital Instruments Example Summary Key Terms and Concepts Questions
CHAPTER 15: LIABILITIES MANAGEMENT Structure of Islamic Bank Liabilities Deposit Sources of Funds Demand Deposits Savings Deposits Investment Deposits Structured Deposits Non-Deposit Sources of Funds Deposits and Placements of Islamic Banks and Other Financial Institutions Profit Equalization Reserves Managing the Net Distributable Income Liquidity Management Factors that Affect Liquidity Financial Market Access Financial Condition Balance Sheet Structure Liquidity Measurement Summary Key Terms and Concepts Questions
367 368 369 371 371 371 372 373
CHAPTER 16: ASSETS MANAGEMENT Structure of Islamic Bank Assets Financing Types of Financing Financing Business Firms Financing for Consumers Financing for Real Estate Financing by Contracts Regulation of Financing
383 384 386 387 387 392 393 394 395
373 374 375 376 377 377 377 377 378 381 382 382
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Pricing Cost-plus Pricing Price-leadership Model Credit-scoring Systems and Risk-based Pricing Firm Profitability Analysis Investment in Securities Investment Instruments Held by Islamic Banks Factors Affecting Choice of Investment Securities Expected Rate of Return Tax Treatment Market Risk Default Risk Liquidity Risk Reserve Management Legal Reserve Short-term Funds Position Management Prudent Risk Management Creates Value for Islamic Banks Sources of Credit Risk Measuring Credit Risk Micro Approach Macro Approach Summary Key Terms and Concepts Questions CHAPTER 17: OFF-BALANCE SHEET MANAGEMENT Motives for Moving Assets Off the Balance Sheet Fee Income as a Catalyst of Off Balance Sheet Activities Off-Balance Sheet Activities Financial Guarantees Letter of Guarantee Standby Letters of Credit Letter of Comfort and Letter of Awareness Remittances Standing Instruction Securities and Fund Services Telegraphic Transfer Tele-banking Travelers' and Bankers' Cheques Cashier's Order /Local Demand Draft Securitisation Cross Currency Swap Summary Key Terms and Concepts Questions
P a r t V I I : THE REAL ECONOMY CHAPTER 18: THE ECONOMICS OF THE ISLAMIC BANKING SYSTEM The Role of Islamic Banks Labour-Based Transactions Financial-Based Transactions Implementing Shariah Law Pooling Savings Channeling Funds Custodian, Payment System Access and Accounting Information Disclosure Economic Contribution Extending Contribution to General Economic Development Benefiting Employees, Customers and Communities Islamic Banks - Value Added Wealth Summary Key Terms and Concepts Questions
CHAPTER 19: THE CENTRAL BANK The History of the Central Bank The Role of Bank Negara The Objectives of the Central Bank Low and Stable Inflation High and Stable Real Growth Financial System Stability Profit Rate and Exchange-Rate Stability The Organizational Structure of the Central Bank The Board of Directors The Governor and the Deputy Governors The National Shariah Advisory Council Organizational Structure Evaluating the Central Bank's Organizational Structure Independence from Political Influence Decision Making by Committee Accountability and Transparency Policy Framework Meeting the Challenges: Creating an Islamic Financial Center MIFC INCEIF Summary Key Terms and Concepts Questions
CHAPTER 20: MONETARY POLICY TRANSMISSION The Transmission Mechanism Monetary Policy Transmission Mechanism The Impact of Monetary Policy Impulses on the Economy Monetary Policy Tools Structure of the Bank Monetary Policy Committee The Tools Open Market Operations Overnight Policy Rate Statutory Reserve Requirements Objectives of Monetary Policy The Role of Operating Targets Rate versus Quantity Variables as Operating Targets The Role of the Monetary Policy Strategy for the Choice of the Operating Target Operating Targets and Monetary Policy Tools The Impact of Monetary Policy Targets on the Bank's Balance Sheet Fiscal Operations and the Central Bank's Balance Sheet Summary Key Terms and Concepts Questions CHAPTER 21: THE ISLAMIC BANKING SYSTEM AND THE REAL ECONOMY Circular Flow Understanding of the Exchange Economy The Production Function The Demand Curve The Supply Curve Equilibrium and the Determination of Output and Inflation Money Flow and Balance Sheet in the Exchange Economy The Size and Composition of the Balance Sheet as Intermediate Targets Bank Capital Bank Liabilities Monetary Base How does the Monetary Policy Work? Evolving Role of Islamic Financial Institutions Summary Key Terms and Concepts Questions
