The official start of Islamic bank began in 1963 with the founding of Mit Ghamr Local Saving Bank in Egypt. The Islamic Development Bank, the world’s first development bank in compliance with the Sharia, was established in 1974.
Islamic banking is an alternative financial system that fulfils the financial needs of both depositors and borrowers, while maintaining high standards of ethics, transparency and sense of responsibility. Two fundamental principles of Islamic banking are the sharing of profit and loss, and the prohibition of the collection and payment of interest by lenders and investors.
In Islamic banking, financial institutions are considered partners of their customers (whether individual or corporate), meaning they share the risks, along with the profits arising from the partnership. Sharia-compliant financial institutions represented approximately 1% of total world assets, concentrated in the Gulf Cooperation Council (GCC) countries, Iran, and Malaysia.
Islamic Banking in Malaysia
Bank of Islam was incorporated as a limited company in March 1983 with the name Bank Islamic Malaysia Berhad (BIMB). In 1993, the Islamic Banking Scheme (IBS) was launched, allowing commercial banks, merchant banks and finance companies to offer Islamic banking products and services, funds and activities of which, however, are required to be carefully kept separate to prevent any co-mingling with the banks’ conventional banking business transactions.
Malaysia’s top two largest banking groups by assets, Maybank and CIMB Group, have both adopted an “Islamic-first” approach in growing their domestic business, offering Islamic products first to all new and existing customers across business lines for individuals, small and medium-sized enterprises (SMEs) and corporates.
According to Bank Negara Malaysia’s (BNM) recent statistics, the Islamic banking system stood at RM747.98 billion at the end of May 2019, 9.3% higher year-on-year (YoY), which further reinforces Islamic banking’s growing success in Malaysia.
Basic Concepts in Islamic Banking
Mudarabah is a partnership or trust financing contract (similar to western equivalent of General and Limited Partnership). A contractual relationship is executed between two parties, one supplying the capital and the other supplying the labor and skill as agent or manager. Each party gets a share of the earnings as determined at the time of the investment for the business activity undertaken together. If there is a loss, the financing party will lose its capital, and the working party will lose the time and effort invested in the project. A wage could be negotiated for the managing party. Such a trust-based contract between capital and labor-managment reflects the Islamic view that the borrower must not bear all the risk/cost of a failure, resulting in a balanced distribution of income and not allowing the lender to monopolize the economy.
Two types of mudaraba contracts commonly exist:
Restricted mudaraba (mudaraba al muqayyadah): The investor specifies a particular business or project where the investment funds are to be used; the working partner should not use the funds for any other business or project.
Unrestricted mudaraba (mudaraba al mutlaqh): In this mudaraba contract, the investor gives the working partner permission to funnel the funds into any type of business or project that best suits the financial goals of both partners.
Unlike in Mudarabah, all partners must contribute capital to the business venture and have the right (not the obligation, though) to executive administrative authority in the venture. Capital contributions must be subject to profit sharing in any ratio agreed between the partners. No benefit to the investors is to be determined at the ourset, while the partners’ losses are to be shared according to the financing share of each partner and may not be limited to the value of their capital contributions.
The partnership may be agreed for a set period of time or be indefinite. It can be established as permanent musharakah in which invested funds are not subject to repayment in the short term, or as diminishing musharakah where invested funds are repaid over time as profitability allows. While still in good standing, partners receive regular accounting and other information on business activity, and permission from existing partners is required before raising capital from new partners. Also, partners may negotiate fixed wages or salaries at the outset of the musharakah.
Termination of the musharakah usually only occurs with the mutual agreement of all partners.