Journal of Islamic Banking and Finance Oct – Dec 2014...

Journal of Islamic Banking and Finance Oct – Dec 2014 1

2 Journal of Islamic Banking and Finance Oct - Dec 2014

In The Name of Allah,


In The Name of Allah,

The most Beneficent, The most Merciful

“O Believers: devour not Riba, doubled and redoubled;

and fear Allah, in the hope that you may get prosperity.”

Sura Ale-Imran (verse No. 130)

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The articles published in this Journal contain references from the

sacred verses of Holy Qur’an and Traditions of the prophet (p.b.u.h) printed for the understanding and the benefit of our

readers. Please maintain their due sanctity and ensure that the pages on which these are printed should be disposed of in the

proper Islamic manner


Journal of Islamic Banking and Finance

Volume 31 Oct – Dec 2014 No. 4 Founding Chairman Muazzam Ali (Late) Former –Vice Chairman Dar Al-Maal Al-Islami Trust, Geneva, Switzerland

Board of Editorial Advisors

Ahmed Ali Siddiqui Mufti Bilal Qazi S. A. Q. Haqqani Dr. Hasan uz Zaman Dr. Mohammad Uzair Altaf Noor Ali (ACA) Chairman Basheer Ahmed Chowdry

Editor Aftab Ahmad Siddiqi

Associate Editor Seemin Shafi

Co-ordinator Research, Accounts & Admin Mohammad Farhan

Published by: International Association of Islamic Banks Karachi, Pakistan. Ph: +92 (021) 35837315 Fax: +92 (021) 35837315 Email: ia _ ib @ yahoo.com Website: www.islamicbanking.asia

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Registration No. 0154 Printed at M/S Maaz Prints, Karachi

International Advisory Panel Dr. Mohammad Kabir Hassan Professor of Economics & Finance University of New Orleans, USA

Professor Dr. Mohd. Ma’sum Billah Scholar (Islamic finance, investment & Halal standard), Malaysia.

Dr. Rodney Wilson Emeritus Professor, INCEIF, Malaysia/France

Dr, R. Ibrahim Adebayo Department of Religions, University of Ilorin, Nigeria

Dr. Huud Shittu Department of Religion and Philosophy, faculty of Art University of Jos – Plateau State, Nigeria

Prof. Dr. Zubair Hasan The Global University of Islamic Finance, Kuala Lumpur, Malaysia

Dr. Mehboob ul Hassan Chairperson and Head of Department, School of Islamic Banking and Finance Al-DAR University College, United Arab Emirates

National Advisory Panel Dr. Waheed Akhtar Assistant Professor, Comsats Institute of Information Technology (CIIT), Lahore, Pakistan Dr. Manzoor Ahmed Al-Azhari, PhD Legal Policy (Shariah Law) Chair, Department of Islamic Studies, (IRER) HITEC University Taxila Cantt, Pakistan.

Mr. Salman Ahmed Sheikh External Reviewer Bankers Academy USA, Research Associate & Faculty Member IBA Karachi

Dr. Muhammad Zubair Usmani Jamia Daraluloom Karachi Muhammad Zeeshan Farrukh MBA (PAF-KIET), CIFP (Malaysia) Director - Research & Development, Attijarah Center of Islamic Economics (ACIE) Member - Association of Chartered Islamic Finance Professionals (Malaysia)


Journal of Islamic Banking and Finance

Volume 31 Oct – Dec 2014 No. 4

C O N T E N T S 1. Editor’s Note -------------------------------------------------------------------------------- 05 2. The Recent Turmoil and Monetary Policy in a Dual Financial System with Islamic Perspective -------------------------------------------------------- 09

By Dr. Zubair Hasan 3. Self-Adjusting Profit Sharing Ratios for Mushārakah Financing --------------- 25

By Dr. Volker Nienhaus 4. Withdrawal Behavior of Malaysian Islamic Bank Customers: Empirical Evidence from Three Major Issues -------------------------------------- 41

By Muhamad Abduh 5. Role of Islamic Banks in Energy Finance in Pakistan------------------------------ 53

By Salman Ahmed Shaikh 6. Consumer Perceptions of Islamic Banks: The Case of Saudi Arabia ----------- 68

By Imran khokhar & Bukhari M. S. Sillah 7. Analysis of The Efficiency Levels of The Sharia Rural Banks in Indonesia Using the Method of Data Envelopment Analysis (DEA) and Its Correlation with Camel ----------------------------------------------- 80 By Muhamad Nadratuzzaman Hosen

& Syafaat Muhari 8. An Application of Shariah Contract on Islamic Retail Investment Products: An Overview on Malaysia -------------------------------------------------103 By Ahmad Aizuddin Hamzah, Farah Shazwani Ruzaiman &

Haneffa Muchlis Gazali

9. Country Model: United Kingdom ---------------------------------------------------------------------------110 10. News Monitor ------------------------------------------------------------------------------112



Editor’s Note Islamic finance is a fast growing industry all across the globe with an asset base

touching $1.7 trillion. On the Sukuk front, the issuance of Sukuk globally reached $117 billion in 2013 from a total of 811 issues, of which 175 were based on the Ijarah structure.

Sukuk could turn out to be an instrument of choice after the current financial crisis. Not only Muslim countries, but non-Muslim majority countries are also taking interest in it. UK treasury issued a Sukuk worth £200 million in 2014. It has become the first sovereign state outside the Muslim world to issue an Islamic bond. Furthermore, the government of Hong Kong had issued its first Sukuk in 2014 to raise $1 billion.

Globally, Malaysia remains a leader in the international Sukuk market, accounting for over $82.4 billion or 68.8% of total international Sukuk issuances in 2013. Recently, the international Sukuk market saw a modest volume of $31.1 billion in new Sukuk issuances in 1QCY14, down by 15.2% as compared to the $36.73 billion during 4QCY13.

Among other regional countries, Indonesia in last few years has issued three sovereign Sukuk of $1 billion to $1.5 billion each. Turkish issuers including the government have also issued Sukuk worth $4 billion internationally.

In Pakistan, 78 Sukuk had been issued so far for an amount of $6.7 billion. Out of the total 78 issues, 32 Sukuk issues for an amount of $1.1 billion had been fully redeemed. Government of Pakistan had issued Ijarah Sukuk on numerous occasions in past to meet its escalating borrowing requirements. Government sector companies like Water & Power Development Authority (WAPDA) and Sui Southern Gas Company Limited (SSGC) had also issued Sukuk in past. Recently, Government of Pakistan (GOP) in the recently concluded International Sovereign Sukuk transaction raised $1 billion for 5 years at an expected profit rate of 6.75% per annum which is 50 bps less than conventional sovereign bond issue. The difference in markup shows that Islamic financing assets are not riskier vis-à-vis their conventional counterparts.

More Sukuk issuance in future can increase the investment choices for Islamic banks and also enable them to have a wider market of firms looking for expansionary investment in long term fixed assets. Furthermore, Sovereign Ijarah Sukuk issued by the governments allows the government to mobilize funds. The Sukuk holders are also able to earn Shari’ah compliant income. It also facilitates Islamic banks to manage their liquidity as well as meet statutory liquidity requirement stipulated by their respective central banks in certain jurisdictions.

In most developing countries, the governments pay more than 50% of their tax revenues in servicing debt and spend very little in development. Often, these governments trim development spending to cover other non-discretionary current


expenditures. Islamic banks can finance the governments for the purchase of infrastructure that can be used in development projects. Lastly, these Sukuk can deepen Islamic money market and provide more investment alternatives to Islamic banks’ treasuries.

Islamic finance products are not only interest free alternatives for the financial needs of the contemporary Muslim communities wanting to avoid interest, but the products are generating increased appeal primarily because of their financial and economic merits. That is why; the Islamic banking industry is growing at a rate twice as much as the conventional banking system.

In the middle of the financial and economic crisis of 2007-10 and even afterwards, the Islamic banking and finance industry has witnessed significant growth in double digits. The two most important problems identified in a post-financial crisis look back are perverse incentives and de-linking of financial sector growth and activities with the real sector of the economy. Islamic finance principles by basing all financial products with real assets fill the gap and this feature alone is a very important risk management tool inbuilt into the system.

Going forward, Islamic banks need to increase their outreach as well as product lines to improve finance to deposit ratio and penetrate more deeply in financing the real sectors of the economy. In Pakistan, Islamic banking industry has achieved a market share of 10% in just about one decade of Islamic Banking in Pakistan since the establishment of the pioneer and premier Islamic bank, Meezan Bank in 2002. Ever since then, the growth in total assets, financings and investments had been exemplary and the sector has attracted almost all the conventional banks in the country to also offer Islamic banking products and services through Islamic Banking Divisions along with 5 full-fledged Islamic banks.

In the challenges to overcome going forward, it is notable that the gap between deposits to total assets and financing to total assets had swelled in recent quarters. This widening gap is after the consumer financing credit crunch and can partly be explained by increased intensity of energy crisis which has hit the manufacturing sector the most severely in Pakistan. Islamic banks with assets backed financial products rely much more on formal documented manufacturing based industries where finance is required for plant and machinery, raw material and industrial equipment.

It is hoped that with renewed focus on Islamic banking by the central bank in Pakistan and revival of economic growth, the Islamic banking industry will further prosper and continue the growth momentum in years to come.

This issue of Journal of Islamic Banking & Finance documents scholarly contributions from authors around the globe. Contributions in this current issue discuss the theoretical underpinnings of an Islamic economy, contemporary issues in Islamic finance and performance based empirical studies on Islamic banking and finance. Below, we introduce the research contributions with their key findings that are selected for inclusion in this issue.

The article on The Recent Turmoil and Monetary Policy in a Dual Financial System by Prof. Dr. Zubair Hasan investigates if the monetary policies the Central Banks follow - including the Basel capital adequacy norms -would suffice Islamic


banking institutions competing with the conventional banks in a dual financial framework? In this context, the article questions the claim that risk-sharing is or can alone be the basis for Islamic finance.

The next article is entitled Self-Adjusting Profit Sharing Ratios for Mushārakah Financing written by Dr. Volker Nienhaus in which he introduces the concept of self adjusting profit sharing ratio in context of contractual agreements in Islamic finance.

In his article based on his study Withdrawal Behavior of Malaysian Islamic Bank Customers: Empirical Evidence from Three Major Issues, Muhamad Abduh discusses efforts that could help in preventing funds withdrawal by the depositors of Islamic Banks in order to avoid bank instability. The study investigates factors that may influence the withdrawal behavior of Malaysian Islamic banks customers. The withdrawal behavior studied is in conjunction with three major issues (i) issues of non-Shariah compliance, (ii) lower returns as compared to other banks, and (iii) rumors about forthcoming financial crisis that may affect the performance of the bank.

Salman Ahmed Shaikh in his paper Role of Islamic Banks in Energy Finance in Pakistan discusses the role of Islamic banks in fulfilling the need of energy shortage. Energy financing presents a vital opportunity for Islamic banks to show their importance and contribution through financing energy infrastructure. He states that Islamic banks will themselves benefit from increased financing to energy sector since it will help them i) narrow their banking spreads, ii) increase financing to deposit ratio and iii) reduce operational inefficiencies. Economy wide effects of resolution of energy crisis will help in increasing investment, productivity, fiscal space and export competitiveness. It will also help in reducing crowding out of private sector credit, capital flight and deindustrialization.

Imran Khokhar and Bukhari M. S. Sillah in their article entitled Consumer Perceptions of Islamic Banks: The Case of Saudi Arabia discuss that in Saudi Arabia, banks which are perceived as non-Islamic banks offer various types of Islamic banking products beside their conventional products. Some of the banks are full-fledged Islamic banks but the Saudi Arabian banks do not carry the word “Islamic” in their names, as they do in other countries. So, they hypothesize that the general public might not attach significance to the distinction between Islamic and conventional banks. The article is based on their study to assess the perceptions of Saudi Arabian people on Islamic banking and to draw conclusions from their views about the degree of the Shariah compliance of the Islamic banking practice.

Then in their article Analysis of the Efficiency Levels of Sharia Rural Banks (SRBs) in Indonesia using the method of data envelopment analysis (DEA) and its correlation with CAMEL, Muhamad Nadratuzzaman Hosen and Syafaat Muhari present the study using non-parametric data envelopment analysis (DEA) with the operational approach to analyze efficiency levels of 73 SRBs during the periods of 2nd Quarter- June 2011to 1st Quarter- March 2013. The level of SRB’s efficiency is further compared to Central Bank (BI/Bank Indonesia) criteria, namely CAMEL (Capital, Asset-Quality, Management, Earnings and liquidity).

Ahmad Aizuddin Hamzah, Farah Shazwani Ruzaiman and Haneffa Muchlis Gazali jointly authored the next paper An Application of Shariah Contract on Islamic Retail Investment Products: An Overview on Malaysia Practice aim to explore the current


Islamic deposit products which are available in the Malaysian market. They talk about The Islamic investment deposit product as one of the tools which increases the capital source of the Islamic financing facilities as an alternative to the conventional interest-based investment deposit product.

At the end of this issue are summarized the significant “News Monitor”- items that show not only the development but also the impact that proponents of Islamic banking and finance are making in their respective markets.

Disclaimer

The authors themselves are responsible for the views and opinions expressed by them in their articles published in this Journal.

The opinions, suggestions from our worthy readers are welcome and may be

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The Recent Turmoil and Monetary Policy in a Dual Financial System with Islamic

Perspective

By Prof. Dr. Zubair Hasan*

Abstract The financial turmoil that the 2007 subprime debacle of the US set into motion has raised a welter of puzzling questions for the policy makers across the world. The position seems all the more confusing in the Muslim world where the fast expanding Islamic finance operates in competition with the conventional in a dual setting.

The turmoil has led many to blaming the private lure for the colossal failure of financial institutions. In contrast, others counter argue to put public policy in the dock under the exalted banner of ‘regime uncertainty’. They blames the aggravation of the trouble on the uncalled for government intervention in financial markets. Interestingly, few draw attention to moral crimes committed on either side of the fence among the causative factors.

This paper seeks to investigate if the monetary policies the Central Banks follow - now including the Basel capital adequacy norms as well - would suit or suffice Islamic banking institutions competing with the conventional in a dual financial framework? In this context, it questions the claim that risk-sharing is or can alone be the basis for Islamic finance.

Keywords: Monetary policy, Dual financial system, Profit sharing ratio, Regime uncertainty

1. Introduction This paper deals with monetary policy in a dual financial system composed of

Islamic and conventional sectors operating in a competitive setting. Monetary policy

* Author: Zubair Hasan is Professor of Islamic Economics and Finance at INCEIF the Global

University of Islamic Finance, Kuala Lumpur. E-Mail: [email protected] The author alone is responsible for the views expressed in this paper and need in no way be attributed to INCEIF where he currently works.


addresses a number of objectives: mobilization of resources for sustainable economic growth, promote distributional equity and keeping the internal as well as external value of money stable. But here we are looking at it from the viewpoint of controls a Central Bank can employ to achieve reasonable stability in the price levels so often disturbed disquietingly by financial crises like the one that has gripped the globe since 2007, the most devastating since the Great depression of 1930s. Such an exercise needs a relook on credit creation process and its efficacy for Islamic banks. As profit sharing replaces interest based financing, determinants of the sharing ratio and what role it could play in controlling credit creation has also to be assessed.

This crisis has not only downed the mighty financial institutions across countries but has bankrupted state after state in Europe. The fall of Lehman Brothers in US in 2008, triggered the onset of the economic devastation the world had never seen after the 1930s (Cihak and Demirguc-Kunt, 2013). The sub-prime debacle in the US pulled off the covering from the Western financial system. Its machinations to enrich bank owners, managers and agents at the expense of borrowers and depositors could no longer remain concealed. Figure 1 shows the process leading to the debacle. Giant banks and insurance companies long considered invincible took little time to crack and collapse in its aftermath. But the US happenings proved only symptomatic of the storm that was fast

crossing the Atlantic. Europe soon found banks failures knocking at the doors of one country after another, the Cyprus bank failures being the latest in the chain. As the institutions were considered too big to sink, keeping them afloat became an unceasing social imperative laced with evil. Indeed, financial crises in the world became more frequent and damaging with the passage of time, the trend is gaining pace after the collapse of Britten Woods arrangements in 19711.

1 The current crisis exhibits a unique and worrisome characteristic. It is moving in a go-halt-

go mode: today is sunshine in the Wall Street, tomorrow the pall of gloom. In 2010 the US economy was seen as out of the tunnel. The BBC on June 18, 2014 informs us that the Federal Reserve has cut for the fifth time the US growth forecast for 2014 to between 2.1% and 2.3%, down from its March forecast of 2.8% to 3%. It has also trimmed back its stimulus programme by $10bn a month to $3.5bn!


According to Global Financial Stability Report (2012), the Euro area crisis remains the key threat to global financial stability. The increasing nexus between monetary and fiscal policies across the globe made many countries on the continent face swelling mountains of sovereign debt. Along with banks, bailing out failing states – Greece, Spain, Portugal, Italy, Ireland, Belgium and now Cyprus are all in deep trouble. Oblivious to this unending scenario across the Atlantic, Islamic economists and financial gurus continue to look westward for guidance and imitation. The average rate of unemployment in Eurozone countries has already hit the 12% mark in 2011. Is it still sense to believe as some do, that “only by replicating conventional structures can Islamic finance create the breadth and depth of its products”? It is time perhaps to think afresh and change course. For this, we have to understand why the theory and practice of the system that inspired developing countries to follow the course failed its own champions so savagely.

2. Risk profit and finance A primary attribute of competition is the tendency to eliminate economic profit or

loss and bring the prices of real goods and services to equality with their money costs. Economic theorists have therefore searched for the source of profit in what makes competition imperfect. Frank H. Knight (1921) convincingly argued that it was uncertainty born of dynamic change that made reality depart from the ideal profitless state in an economy. Uncertainty breeds risk and divides the society into those who prefer to take risks in the expectations of large gains and those who want to avoid risks in favor of getting sure specific even if smaller incomes. Risk-preference and risk-aversion divided human beings into the hired and un-hired production factors in all societies independent of time and space.

Entrepreneurs, however defined, fall in the un-hired category. They guarantee fixed specific returns to the hired factors of production – money lenders, workers and property owners – in the form of interest, wages and rent. Entrepreneurs choose to be claimants of the residual business earnings in the expectations of large gains but have to simultaneously expose their investment to the risk of shrinkage (loss) if revenue receipts belie expectations and fall short of payments due to the hired factors.2

2.1 Risk-sharing versus risk-transfer This inevitable division of people into hired and un-hired factors knocks at the

bottom of a plea now gaining currency in Islamic economics. It is being argued that risk-sharing could alone be the Islamic basis of pecuniary contracts. To be sure, this is not a new plea. Only a new garb is being provided to the old edict ‘no risk, no gain’ is an adage long paraded in Islamic finance. No one disputes that participatory finance is in principle a more desirable rather preferred mode for Islamic financing. But projecting that risk-sharing is the only form acceptable to the system raises ticklish issues.

2 Now ism connotes a creed an ideology and a movement that persistently guards and

promotes some specific interest economic, social, political and so on. Thus capitalism is an economic doctrine that evolved and grew into an institutional system to protect and promote the interests of capital owners in the world. Thus seen, the term ‘Islamic capitalism’ that recently gained currency seems to me internally inconsistent


First, there is little positive support for risk-sharing in the demonstration, however convincing, in showing what havoc risk-transfer has brought to world economy over time and space unless one can produce empirical evidence as to what risk-sharing could do in the present era.

Second, it may be argues that with eloquence that risk-sharing was the divine desideratum to promote mutual help and cooperation and peace among humans who had opted to run affairs on Earth as the vicegerent of Allah (swt). But what has man done; especially what Muslims are doing?

Third, leave the cosmopolitan approach aside and take the organization of economic activity within a country. All factors of production are exposed to risk, not capital alone. Workers are exposed to unemployment – there may not be coal I the house as there is too much coal in the market. Involuntary mass unemployment may and has occurred, due to natural calamities, wars to serve economic interests – Millions became penniless when Americans disbanded the Iraqi army with a wave of hand. Bridges, buildings, coal mines, nuclear plants collapse, many work in hazardous industries. Limb and life is lost. Who shares the risk with the hapless? Such risks are much more devastating for societies than the loss of money in business.

Fourth, ivory tower thinkers must avoid the glitch of considering risk sharing or transfer merely or largely an issue between groups of capital owners. Labour shares the risks too. So must share profits as well.

Fifth, risk-sharing cannot be detached from profit (loss) sharing. Risk being an ex-ante non-measurable variable, a one-on-one correspondence cannot be established between the two. Thus, a society based only on risk-sharing cannot be expected to ensure distributive justice and stay strife free. We cannot hope to put people long on opium.

Finally, it is misleading to suggest that current Islamic financing is all based on risk-sharing or all conventional finance is just deceitful risk-transfer. Only 20% is the share of participatory modes in Islamic finance; thus debt-based transactions – leasing and murabahah - dominate. In fact scholars are going to the extent of asking: Is Islamic finance in Malaysia interest free? And, there is even an opinion that pure mudarabah involves risk-transfer from the financier to the worker which may ex post turnout less than the transfer earning of the latter. If so risk-sharing would become exploitative of the worker.

The logic of capitalism not only presupposes the existence of hired factors of production - workers and the natural resources - but also of an initial facility of finance provided by bank credit to pay for wages. The recent heterodox view that finance is a sort of invisible ex ante flow in modern economies has elements of truth; it links well with Keynes according recognition to the importance of money as financial asset. The recognition led to viewing money as an interest bearing claim the banks could create or destroy at will in response to variations in the demand for money (liquidity) even though it carried no intrinsic value. One reason, among others, for allowing banks to create credit is that the act facilitates the adjusting of supply of money to seasonal variations in its demand.

Islamic banks operate in a capitalist system in competition with their conventional counterparts. They cannot do business in defiance of the systemic requirements; they can


possibly observe the Islamic ban on interest but would find survival difficult without credit creation. Fractional reserve system is a pre-requisite for credit creation. Hence, suggestions of keeping 100% reserve against deposits in Islamic banking are impracticable. It would thus be helpful to see briefly how banks create credit to understand and evaluate measures central banks use for controlling it to keep the system stable.

3. Credit creation process How the fractional reserve system enables banks to create credit money is easy to

see. Initially banks have cash deposits. Each bank knows by experience that on a normal day most people withdraw only a fraction in cash from their accounts. So, retaining a safe fraction of cash deposits, the bank lends the rest to a third party on interest. But it asks the borrower to open an account with the bank to deposit in the loan money. Thus, loans create deposits. The bank treats credit deposits as cash deposits and advances loan out of loan so to say. The process multiplies deposits raising their inverted pyramid. Suppose each bank retains on an average F fraction of cash deposits as reserve to meet the daily withdrawals while the central bank of the country wants banks to maintain with it a minimum fraction R of their deposits – cash + credit – in the form of cash. How much credit can a bank create given these constraints? The credit multiplier M provides the answer. Ignoring proof, M can be calculated as under.

M = 1/F [1 – R] (1)To illustrate, assume a bank has $50m in cash deposits and has to keep F = 0.1

fraction of the sum every moment in its safe to meet the daily withdrawal demands. Furthermore, suppose that each commercial bank is required to maintain 5% of its deposits –cash plus credit - in in the form of cash with the Central Bank, implying that R=0.05. The credit multiplier M wil then be 10 x 0.95 = 9.5. The 50m cash deposit with

Figure 2: Inverted credit pyramid with F = 1 / 10 and R = 1 / 20 (Multiplier M = 9.5)

then be 10 x 0.95 = 9.5. The 50m cash deposit with the bank will enable it to have a total deposit worth 50 x 9.5= 475m. If we take out $ 50m cash deposits from the total, the remaining $425m would be the credit-on-credit or loan deposits the bank has generated. Figure 2 presents a schematic depiction of how the process creates an inverted credit pyramid in the economy. Note that an individual bank cannot create credit disproportionate to others because on balance it will soon find its net cash inflows


reducing via inter-bank clearances. The cash string forces it to remain with the group. However, the credit creation power of the banking system as a whole is tremendous as mutual claims against each other are largely cancelled. The interest received on this huge amount minus the part of it payable to cash deposit holders and other operating expenses will all belong to the bank owners which they share with their managers and agents.

Banking is thus an exceedingly lucrative business. Maturity transformation via renewals converts short-term credits into long-term funding. Leverage gains tend to make businesses over-adventurous. Rising profits lure banks continue pumping in the air until the bubble burst, economies roll down the hill; unemployment becomes rampant. Rising leverage gains fuel greed and have largely been the cause of frequent financial turmoil like the one world faces since 2008. The solution is seen in strengthening the capital base for restraining credit expansion beyond the limits of safety. Standard capital adequacy ratios are being developed under what are known as Basel Accords3. Islamic financial institutions have also to fall in line. Monetary authorities in various Muslim countries and the IFSB are seized with the issue: the regulatory frameworks are being revamped and new standards are being designed.

4. The determinants of profit sharing ratio Participatory finance is regarded as the high point of Islamic finance where losses

are shared in the same ratios as the capital contributions but the sharing of profit arrangement is not to be the same. The interesting question then is how the sharing of profit ratio is determined? Of course, it is settled by negotiations between the parties. But there have to be some factors guiding the negotiations. Mudarabah is a contract in which a financier, say a bank, provides funds to an entrepreneur (firm) for investing in a business venture to share profits in an agreed proportion, losses falling on capital alone.4 This view implies what we may call a pure mudarabah model where the financier is assumed to provide the entire capital to an empty handed entrepreneur; the model fits well even today to small partnership businesses to undertake specific projects. But the modern economic scene is dominated by large corporations that have long eclipsed small proprietary businesses. Likewise, banks have almost completely replaced personal

3 For a critical evaluation of Basel Accords, see Hasan (2014). The Capital Adequacy ratio is

found as under. Tier 1 capital + Tier 2 capital CAR = ≥ 1

Aggregate risk − weighted assets “Capital adequacy ratios are a measure of the amount of a bank's capital expressed as a percentage of its risk weighted credit exposures. An international standard which recommends minimum capital adequacy ratios has been developed to ensure banks can absorb a reasonable level of losses before becoming insolvent. Applying minimum capital adequacy ratios serves to protect depositors and promote the stability and efficiency of the financial system”. The Central Bak of New Zeeland.

4 Paraphrasing Bank Negara Malaysia, mudaraba is an agreement made between a party who provides the capital and the other - an entrepreneur – who is thus enabled to carry out business projects on the basis of sharing profit in pre-agreed ratios. However, losses, if any, are borne solely by the provider of funds. Bank Negara Malaysia http://www.bnm.gov.my/index.php?ch=174&pg=469&ac=383


financing of the earlier era with institutional arrangements. What realistically fits in the present situations is the model of what we can term as mixed mudaraba, where the bank is an outside financier providing fund to running businesses on a profit sharing basis. Corporations operate mostly with their (owners) shareholders’ money supplemented by bank finance, if need be. Banks mostly use customer deposits for provide finance to various sort of borrowers – individuals, firms and public institutions.

Banks mostly employ two-tier mudarabah models to work as financial intermediaries. On the one hand they obtain deposits from the clients under profit (loss) sharing arrangements, on the other hand they finance clients using the deposits plus their own money under the same sort of profit (loss) sharing contracts. It is obvious that the sharing ratio of profit with the depositors would be less than the sharing ratio with the borrowers, the difference being the banks’ margin (Hasan, 2008). We shall show that the sharing ratio with the depositors can be used as a credit control measure by the central banks.

5. Profit sharing ratio and credit control In the classical view of mudaabah the entrepreneur was an empty-handed person

the financier providing the entire capital. The business constituted a one off short-run project; the concept of a large sized running business requiring perennial investment with changing owners was not there. The scenario today is totally different. Corporate businesses need large investments on a long-run basis; Mudarabah has to join in a participatory financing program. In such a program the bank as mudarib would mostly provide only part – say λ fraction - of total capital K invested in a business. Thus, borrowed amount of money L divided by K would equals λ Thus, λ operates both as the loss sharing ratio for the bank as also the leverage measure for the borrowing firms. The business owners’ portion in capital would thus equal (1- λ) K. Of course, losses, if any, are to be shared between the firms and the bank in the same ratios as are their capital contributions i.e. (1-λ) and λ respectively.

In mixed mudarabah profit sharing applies to earnings that are allocable to the part of capital K a bank provides to the firm. Thus, if P were distributable profits, λP would be allocable to the bank the pure financier. It is this part of profit which is the subject matter for sharing with the firm. Negotiations between the two lead to the decision that a fraction of this, say σ*, will go to the bank and the remaining (1- σ*) the firm will retain for entrepreneurial services it rendered to make bank money earn a return. It is easy to see what goes to the bank is a smaller fraction, say σ, of total profit P than σ*. For, σ* λP, the bank’s profit share, divided by P would equal σ* λ. In σ = σ* λ both σ* and λ being less than 1, their product σ must be smaller than either of them. The derivation of σ allows the treatment of the ratio issue at the macro level and helps construction of models to show, as in equation (2), that profit sharing ratio σ is a function of four variables i.e. the expected rate of profit r on capital K, the proportion of borrowings λ in K, the market rate of interest ri and the risk premium or economic profit α (Hasan, 1985).

σ = λ

(r + α) where, λ (ri + α) < r because σ < 1 (2) R i


It follows from equation (2) that in a competitive setting the sharing ratio σ for the bank at the macro level varies inversely with profit expectations r and directly with the remaining three determinants λ, ri, and α . We now change the explanation of these variables with reference to the mudarabah contract between the banks and their depositors so as to forge a credit control measure for Islamic banks.

We assume r to be the rate of profit on capital K that a bank invests in business (r = P/K). The bank has (1- λ) and the depositors λ share in K. Likewise, σ* is the banks’ ratio for the sharing of profit with the depositors. Now, suppose the maximum leverage gain (risk premium) the central bank allows to banks is β. The upper limit for return on bank investment share KB = (1 – λ) K would thus be r + β the remaining profit accruing to depositors on their investment KD = λK. From profit P, the amount (1 – λ) P would be allocable to the bank on its share in K but it will also get σ* fraction of profit allocable to the deposits i.e. of λ P. Thus, for the bank we may set up it is obvious from equation (3)

(1− λ)P + σ * λP(1- λ) K = KB

≤ r +β ≤ 1

r (1− λ + σ) (1− λ) ≤ r + β We have KP

= r and σ = σ * λ as above

This reduces to

σ ≤β r . .(1− λ) ≤ 1 (3)

that for any given values of r and λ the profit sharing ratio (PSR = σ ) for the bank would vary directly with β. Thus, β can be a cost free policy variable that the central bank of a country can use for mandatory ex post adjustment of the PSR in Islamic finance to enforce fairness in the distribution of mudaraba profits between the banks and the depositors.

The use of the instrument would also force banks to adjust their leverage ratios via σ of equation (2) to harmonize with changes in β. For, the introduction of β as the control variable into the picture would by definition affect α in equation (2) impacting in the process the size of σ the banks’ profit sharing ratio with businesses that is making credit costlier or cheaper for the latter.

Equation (2) provides us a common sense but useful link between the profit sharing ratio of the banks and the rate of interest in a dual monetary system. Let us merge α with ri and put λ /r = µ to make analysis easier. Take µ as a constant implying that only r and λ could vary such that their ratio stays unchanged.

We now have a linear equation σ = µ (ri+ α) which passes through the origin µ being its slope. It sets up a positive relationship between profit sharing ratio σ and the rate of interest plus α as shown in Figure 3. It follows that for the same ri the profit sharing ratio σ may fluctuate with changes in leverage λ or profit expectation r or α. But it could also remain constant, if changes in λ and r take place in the same direction such that µ remains unchanged.


It follows that if the central bank of the country lowers β that would increase the rate of return to the depositors leading to a reduction in bank margins. To keep their margins intact the banks are expected to demand higher profit sharing ratio σ from the borrowing firms reducing the leverage lure and profits. Thus, β can be an effective control measure to curb inflation. During recession an increase in β could boost the sagging business morale through brightening profit expectations. Demand for investment funds may look up and credit creation may fill up emerging gaps.

The use of β as a credit control measure in a dual financial system has several advantages over the traditional bank rate policy. Bank rate policy operates through the manipulation of the money use price which conflicts with the Islamic ban on interest. In contrast, ϑ leaves interest rate untouched; it operates directly on profit margins of both the financiers and the borrowing businesses having a better psychological impact. Interest rate is a blanket measure. It affects borrowings for all purposes in equal measure – relatively more urgent and socially desirable or frivolous. Possibly,ϑ proves more amicable to pursue discretionary policies i.e. for selective control of investment channels. Finally, changes in interest rate affect the entire financing system – all purposes, all modes and all markets restricting the frequency of using it; β is more flexible (Hasan, 2010).

6. Other credit control measures Open market operations:

Normally, the Central bank of a country does not enter the financial markets but occasionally uses the right to encourage credit expansion or contraction through impacting the credit creation base of the commercial banks. It can do so because it always carries a stock of first class treasury bills and commercial securities. As opposed


to interest rate the price of credit, open market operations affect the cash-base of commercial banks and thus their credit creation capability.

When the economy is climbing up money incomes tend to expand at a faster rate than real output (why?). Prices rise and the economy soon finds it in the grip of inflation. To reduce cash base with commercial banks, the Central bank starts selling securities in the open market competing with other sellers. The people purchasing these securities issue checks on their banks. Cash moves out from the banking system into the coffers of the Central banks. Credit multiplier is expected to work in to opposite direction exercising a dampening effect on price level. The action is reversed if the economy turns direction and going down the hill – deflation is taking place. The Central bank starts buying securities in the open market. Papers pile up with the bank, money being pumped into the system and credit creating ability of commercial banks rises. The policy may not succeed if people keep sale proceeds with them or demand for funds stays unresponsive. For, one can take a horse to water but cannot make him drink against his will.

Open market operations have some serious limitations as a measure of credit control. During inflation, the prices of fixed return securities – Islamic or non-Islamic – tend to fall because of better income avenues now available for free funds. Thus, in all probability the Central Bank must sell securities at prices lower than at what it may have purchased them. In the same way, it must purchase securities at higher prices during recession compared to new investments. Thus, it is likely to incur losses on purchases too. How much loss of money the bank can take and justify it in a democratic set up is an important question5. As open market operations too work via affecting return on securities divergent from the coupon rates, the method departs from Islamic norm of avoiding interest. Statutory reserve requirements

We have mentioned earlier that the scheduled commercial banks – conventional or Islamic – have to maintain a certain percentage of their cash deposits in their accounts with the central bank. This ratio can be increased or decreased by the central bank. The central banks use the ratio variation discretion as a measure of credit control. As this policy measure contracts or expands the cash base of the commercial banks it is an effective measure in the hands of

Cash deposit ratio. As a supplement to the statutory reserve requirement the central banks have a

second string to their bow – the cash-deposit ratio. While reserve maintenance with the central bank makes commercial banks part with cash, they are not obliged to so in case of cash-deposit ratio. Here the banks do not lose their hold on cash but only have to maintain a minimal of cash with them defined by the ratio the central bank indicates from time to time. The impact of variation in the ratio is the same as variation in the reserve

5 The Federal Reserve has recently been buying bonds ad pumping money into the economy

to keep long-term interest rates low to encourage borrowings from the banks. However, either the policy is not succeeding or the Fed is losing money on purchases; for It also trimming back its stimulus programme now to $3.5bn from $ 10bn a month (BBC News 2014) central banks. They lower the ratio to overcome recessionary trends in the economy and raise the same when inflation is rearing its head.


maintenance ratio. Islamic economists have no reservations about the use of the two ratios as methods of controlling credit creation by banks (Ahmad, 2008). Moral suasion

Finally, as the Central Bank has special privileges and power, especially as the lender of the last resort it acts as a philosopher, friend and guide to all commercial banks in the system. Banks listen to its advice. Sometimes a circular issued to the banks concerning credit management may have the desired impact. Thus, ‘moral suasion’ is counted among the methods of credit control.

There have been claims that Islamic banks withstood the current crisis better than their conventional counterparts. Several studies including Hasan and Dridi (2010), Lewis (2008), and Mirakhor (2007), indeed found that Islamic banks are generally more resilient to the crisis than the conventional. Cihak and Hesse (2010) find that small Islamic banks are stronger financially than small conventional banks. Beck et.al (2013) conclude that Islamic banks perform better in terms of capitalization, asset quality and are less likely to disintermediate during crisis. But there are also those who do not subscribe to this view. Bourkhis and Nabi (2013) for example, show that there is no significant difference in terms of the effect of the financial crisis on the soundness of Islamic banks and conventional banks.. One comes across some interesting observations on the issue in the IFSB 2013 Stability Report. The opening observation says that Islamic banks are found in a comparative study more resilient than the conventional; the reason being their sturdy capitalization ratios. But the Report hastens to add that these ratios for Islamic banks declined in Asian jurisdictions in 2007-2011, while conventional banks augmented their capitalization during that period (Executive Summary). Thus, the debate on the point remains inconclusive.

For us, Islamic banking is too small and has not yet developed the connectivity with the global system to attract infection. In any case, not a few Islamic banks did come to grief, especially in the Middle-East. Kuwait has recently refused to bailout the defaulting banks in the country. In sum, time has not yet come to feel elated; many hurdles have to be crossed; challenges have to be met to bring ground realities closer to aspirations.

7. Some related issues We now turn briefly to the three issues gaining currency in discussions on Islamic

banking in the wake of the ongoing financial turmoil across the globe. These include (a) Islamic banks have not been much affected by the current turmoil which shows the comparative resilience of their modus operandi (b) risk-sharing is or should be the sole basis of financing in Islam and (c) the efficacy of governmental intervention to pre-empt such crises in future.

(a) Current financial crisis and Islamic banks Introductory section of this paper provided a thumbnail sketch of the financial

crisis that has downed mighty banks even governments in the West over the past more than five years and gives little hope of abating. During this period has emerged a new line of thought combining two propositions. Islamic banks have faced the crisis better than the conventional testifying to the inherent strength and resilience of the system. This strength follows from a close link between financial flows and productivity in the real sector of the economy. Nabi (2012) finds that the presence of diversification in Islamic banking


sector across countries reduces the vulnerability of financial contagion. Ahmed (2010) confirms: “This intrinsic property of

Islamic finance contributes towards insulating it from the potential risks resulting from excess leverage and speculative financial activities which are part of the root causes of the current financial crisis”. Abbas (2007) contains similar views. True, the factors mentioned in these writings might have kept Islamic banks less affected during the crisis but at the same time we cannot ignore certain other factors which softened the impact crisis on Islamic banks. Consider for example the following points.

1) Islamic banks are still too small to attract the contagion because of their tiny existence; the ratio of Islamic banks asset to the conventional is just 1:164 in 2011 even as it has been improving over the years6 It has climbed down to 1:112 in June 2014.

2) It does not probably take one far to say that Islamic banks are not affected because they are based on profit and loss sharing. To be frank, the contribution of Islamic banks to participatory finance has still not crossed the 20% mark, the remaining transactions are essentially debt-based. (Hasan 2014)

3. Islamic banks have not yet developed enough connectivity with the mainstream system for the transmission of the contagion. Even then, it is not true that Islamic banks have not at all been affected. It is on record that several banks including Nakheel of UAE landed in trouble and the state have to bail out and Kuwait refused to bail out their failing banks.

4. Most comparisons employ econometric models where sample designs, reliability of data as also their homogeneity over time and space may be carry question marks. Particularly infection within the system units is a smaller

Figure 4: Islamic Banking global growth trends Source: IFSB Survey Report 2013 (Modified)

6 The ratio is based on the volume of global financial assets being $213 trillion (IMF

Financial Report 2013 and Islamic financial assets $1.3 trillion according to a Reuters 2012 study.


matter than the overall macro impact of the turmoil on various banking variables. Here the injury is not the result of financial markets chaos; it is just its reflection. It is the consequence of wide and wild lurching of the broad macroeconomic variables – national income, savings, investment, money supply taxation, wage levels and so on. Figure 4 is revealing on the point.

(b) Risk-sharing as the sole principle for Islamic finance From the perception that Islamic banks have faced the financial crisis better than

their conventional rivals some Islamic scholars – particularly my friend Abbas in his various writings – probably thought that the basic reason is the avoidance of interest in Islam. This view has some serious implications: (i) interest based financing is entirely risk-free (ii) Islam does not allow fixed return on investment in any circumstance, (iii) No risk transfer is involved in a sharing scheme and (iv) finally, risk-sharing is automatically equitable. Let us examine if these implications are tenable.

In fact, pleading for risk-sharing as the sole permissible Islamic principle for financing is not new: it is a re-echo of the age long precept of the earlier Islamic economists epitomized in the Chapa’s ‘No risk, no gain’ rule highlighted in his 1986 publication Towards a just monetary system. The evaluation of the precept was central to Hasan (2005). I need not reiterate my position here.

Now, the success of any policy to pre-empt future turmoil and maintain economic stability presumes a minimal honesty in intention and operation on the part of those who implement the reforms. And it is here that many are not sure of the required integrity. They cite the evidence from the happenings that led to the current debacle: interest-rate-property-price manipulation to reap speculative windfalls by the bank owners and managers (Bianco et al 2008) Figure 5 throws some light on the connection, the lagged

Figure 5: Low interest rates pushed up property prices but before the buyers could take in profit hikes in interest rates caused the crash in the property market. Fore closures mounted. Mortgage market debacle snowballed to other sectors of the economy and across countries.

response seems to reveal. In section X falling interest rates eventually pushed up property prices leading to expansion of mortgage loans. Interest rates gradually climbed up in Y


section. Property prices continue rising for a while before correction could take place. Soon property price crashed, foreclosures became rampant, collapsing banks in the process. In section Z interest rates touch the bottom, property prices recover slightly but then dip irrevocably: the crisis was well on course. Nicholas Ryder (2014) provides a detailed and graphic chronicle of crimes leading to the near collapse of the western financial system. In the process he raises some exceedingly important questions doubting the system’s ability even to recognize such crimes, let alone its ability to address them.

Such sort of doubts revitalized old arguments in favour of governmental non-intervention in the markets. Recently, it was Robert Higgs (2012) who set the ball rolling: he saw the genesis of financial crises in the governmental intervention in national economies through the abridging of property rights and their mishandling. Higgs wrote:

In my conception regime uncertainty pertains above all to a pervasive uncertainty about the property-rights regime—about what private owners can reliably expect the government to do in its actions that affect private owners’ ability to control the use of their property, to reap the income it yields, and to transfer it to others on mutually acceptable terms.

Palpably, it is the reiteration of the old laissez faire doctrine that walked smart in the guise of liberalization towards the closing decades of the last century.

However, dissentions to non-intervention today are much louder. The global financial crisis has given greater credence to the idea that active state involvement in the financial sector can help maintain economic stability, drive growth, and create jobs. There is evidence that some interventions may have had an impact, at least in the short run. Even as there is some evidence that governmental intervention might have negative effects in the long run, it does not mean that the state should desist from keeping an eye on financial happenings to be caught napping (Cihak 2008; and Demirguc Kunt, 2013).

Islam stands for freedom of the individual and the markets but not at the cost of social well-being and fair play. The religion is not anti-rich and grants all protection to private earnings and wealth. But its norms of legitimacy are not a matter for market arbitration. State regulation of market behavior and practices carries undisputed evidence over time and space in history. Islamic requirements for the fulfillment of basic needs, removal of poverty, reduction in inequities and keeping the balances straight in all spheres of life presupposes a substantial state intervention in the economic life of the community with discretion. Government intervention in economic activities under Islamic dispensation is to be a source of certainty, not of uncertainty.

Let one understand that capitalism is in essence a system that free markets operate to protect and promote the interests of the capitalist class the world over through persuasion or oppression. Apart from unabated availability of human labor, natural resources and instruments for production, it pre-supposes the existence of a financial system to lubricate the wheels of trade industry and commerce. Islamic banks chose to join the competitive race of the system. In this competition, they cannot avoid credit creation which is the life blood of modern interest-based financing. Operating in a dual financial system, Islamic banks cannot survive without following conventional banks in some ways not to their liking albeit they can possibly avoid using the institution of interest and what goes with it.


In continuation, it is fallacious to argue that Islam approves only risk-sharing as

basis of economic organization. And, to restrict it to finance alone implies that the dispute is conceived as within the capitalists’ house to the exclusion of other cooperators in production, especially labour. To that extent, the talk of justice in sharing may perpetrate injustice. Islam does allow fixed returns to factors of production; it grants even time value for money in deferred payment contracts. Let us be clear that an economy cannot work without a fixed incomes’ benchmark. It is like seeing geography work without the sea level being the reference for measuring heights. Are not Islamic banks currently using interest rates for bench marking? (Shaukat 2014)

8. Concluding remarks We have examined the instruments central banks can use to regulate credit creation

from Islamic perspective and have suggested a new measure based on the Islamic profit sharing norm. Its merit is that it can impact both categories of banks – Islamic and conventional – in the same direction without imposing costs on the central banks.

The year 2009 was a critical for Islamic Finance as the downturn tested the resilience of the institutions and financing structures that endeavor to comply with the ethical and moral investment guidelines that form the core of the Shariah law. The crisis, however, showed that the sector has not been without its casualties, with high-profile Islamic names such as Tamweel, Amlak and The Investment Dar falling foul of the credit crunch (Howladar, 2010). Thus, the industry is likely to face increasing challenge in the future. Diversification, product innovation and standardization of norms and harmonization of regulations across countries can go a long way to help Islamic finance industry face the impeding challenge.

Islam stands for freedom of the individual and the markets but not at the cost of social well-being and fair play. The religion is not anti-rich and grants all protection to private earnings and wealth. But its norms of legitimacy are not a matter for market arbitration. State regulation of market behavior and practices carries undisputed evidence over time and space in history. Islamic requirements for the fulfillment of basic needs, removal of poverty, reduction in inequities and keeping the balances straight in all spheres of life presupposes a substantial state intervention in the economic life of the community with discretion. Government intervention in economic activities is to be a source of certainty, not of uncertainty under Islamic dispensation.

However, to pronounce ethical norms is one thing; to see them operate on ground is quite another. It will far from truth to opine that conventional financial settings are devoid of ethical norms of behavior; the lament is that it is the blatant continual violation of these norms that has dragged the world to the brink of disaster.

References Ahmad, A. (2008) ‘Monetary policy in Islamic framework’, [Online], Available:

http://www.ausafahmad.info/monetary_policy_islamic.ppt Ahmed, A. (2010) ‘Global financial crisis: an Islamic finance perspective’, International

Journal of Islamic and Middle Eastern Finance and Management, vol. 3, no. 4, pp. 306 – 320.

BBC News (June 18, 2014: The Federal Reserve has cut the US growth forecast for 2014 http://www.bbc.com/news/business-27913695


Beck, T., Demirguc-Kunt, A., Merrouche O. (2013) ‘Islamic vs. conventional banking: Business model, efficiency and stability’, Journal of Banking and Finance, vol. 37, pp. 433-447.

Bianco, Katalina M. et al (2008): The Subprime Lending Crisis: Causes and Effects of the Mortgage Meltdown CH Mortgage Compliance Guide and Bank Digest.

Bourkhis, K. & Nabi, M.S. (2013) ‘Islamic and conventional banks’ soundness during the 2007-2008 financial crisis’, Review of Financial Economics.

Cihak, M and Demirguc-Kunt, A. (2013): Rethinking the state's role in finance. Policy Research WPS 6400. The World Bank.

Cihak, M. and Hesse, H. (2010) ‘Islamic banks and financial stability: an empirical analysis’, Journal of Financial Services Research, vol. 38, pp. 95-113.

Hasan, M. & Dridi, J. (2010): ‘The Effects of Global Crisis on Islamic and Conventional Banks: A Comparative Study’, IMF Working Paper 10/201.

Hasan, Z. (1985) ‘Determination of Profit and Loss Sharing Ratios in Interest-Free Business Finance’, Journal of Research in Islamic Economics, vol. 3, no. 1, pp. 13-27.

Hasan, Z. (2008) ‘Islamic Banks: Profit sharing, equity, leverage lure and credit control’, Journal of King Abdul Aziz University: Islamic Economics, vol.13, no. 1, 2010 pp. 1-19.

Hasan, Z. (2010):‘Profit sharing ratios in mudaraba contract’, International Journal of Islamic Banking and inance. vol. 7, no. 1.

Higgs, Robert (2012) Regime Uncertainty, Then and Now, [Online], Available: http://www.fee.org/the_freeman/detail/regime-uncertainty-then-and-now#ixzz2M5ujJfFs

Howladar, K. (2010) ‘Shariah risk: Understanding recent compliance issues in Islamic finance’, Moody’s nvestor Service Report, p.1.

International Monetary Fund (IMF), (2012) Global Financial, Stability Report: Restoring Confidence and Progressing on Reforms, Washington: IMF Publications.

Keynes, J.M. (1930) ‘A treatise on money’, New York: Harcourt, Brace and company. Knight, F.H. (1921) ‘Risk, uncertainty and profit’, New York: Houghton Mifflin

Lewis, M. K. (2008) ‘In what ways does Islamic banking differ from conventional finance?’, Journal of Islamic Economics, Banking and Finance (JIEBF) , vol. 4, no. 3, pp. 9-24.

Mirakhor, A. (2007) ‘Islamic finance and globalization: A convergence?’, Journal of Islamic Economics, Banking and Finance (JIEBF), vol. 3, no. 2, July - December , pp. 11-72.

Nabi, M.S. (2012):‘Dual banking and financial contagion’, Islamic Economic Studies, vol. 20, no.2 December, pp. 29-54.

Ryder, Nicholas (2014): The Financial Crisis And White Collar Crime -The Perfect Storm? Available as an eBook . Elgaronline.

Shaukat, Mughees (2014): Wavelet Analysis of Deposit returns. Conventional and Islamic Contingency: The Malaysian Saga, Journal of Islamic Banking and Finance, Vol. 3, No. 2 April-June, PP.67-82


Self-Adjusting Profit Sharing Ratios for Mushārakah Financing

By Dr. Volker Nienhaus*

Abstract Islamic economists have propagated contractual arrangements for a sharing of profits between capital providers and entrepreneurs and the bearing of losses by the capital providers (mudārabah, mushārakah) as the “true” Islamic alternative to interest-based debt financing. But this ideal is very difficult to implement in a world with distinct information asymmetries, self-interested market players, adverse selection problems, and debt-like Shariah compliant financing techniques with more predictable and less risky financing alternatives. Wrong profit expectations at the beginning of a profit and loss sharing contract can adversely affect the return on the invested capital. The standards of the Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI) has come up with a number of possible corrections for expectation errors, but they all require a consensus of all contracting parties on a modification of the initial agreement. Since the purpose of re-negotiations is a re-distribution of profit shares from one party to another party, a consensus among self-oriented actors is not very likely. The proposal of a self-adjusting profit sharing ratio obviates the need for discretionary re-negotiations. It uses elements from AAOIFI standards to structure a contractual arrangement that maintains a distribution pattern which was initially agreed upon by the contracting parties. It does so by an automatic adjustment of the profit sharing ratio whenever new information on the expected profit becomes available. This reduces the impact of information asymmetries and reduces the risk of adverse selection, and the formula for the profit sharing ratio can be calibrated such that a risk aversion of the financier is factored in. Keywords: Islamic finance, mushārakah, profit and loss sharing, information asymmetries.

* Honorary Professor, Faculty of Economics and Business Administration, University of

Bochum (Germany); Visiting Professor, ICMA Centre, Henley Business School, University of Reading (United Kingdom), Adjunct Professor, International Centre for Education in Islamic Finance, Kuala Lumpur (Malaysia). Contact: [email protected], phone +49 201 8695750, fax +49 201 8695752.


1. Discrepancies between a Model and the Practice of Islamic Finance Islamic economists consider finance based on profit and loss sharing (PLS)

(participatory finance) to be the genuine Islamic mode of finance that distinguishes Islamic from conventional finance. Indeed, an economic system where PLS is the dominant mode of financing would have different qualities with regard to efficiency, stability and distribution compared to a conventional interest and debt-based system. However, Islamic bankers and Shariah scholars never shared the enthusiasm of Islamic economists for PLS financing in practice. It is not that Shariah scholars did not allow PLS arrangements: mudārabah and mushārakah contracts are explicitly approved as Shariah compliant. But the approval was done in a way which opened the door widely for practitioners to convert the participatory contracts into close functional equivalents of conventional interest-based and risk-minimizing modes of financing. In particular, Shariah scholars have factually approved the conversion of “equity-based” sukūk (participatory instruments with a variable return) into “Islamic bonds” (fixed-income debt instruments).

2. Avoidance of PLS Financing in Banking The absence of participatory finance in banking can be explained both by

theoretical and practical arguments.

(1) Textbooks and papers written by Islamic economists usually presented a very specific model of PLS financing. They assumed that mudārabah and mushārakah financings require the ex ante fixing of a profit sharing ratio as a percentage of the profits that will be realized during the life or at the end of a PLS contract. More specifically, the basic assumptions were the following:

• The profit sharing ratio is negotiated and stipulated when the contract is signed, e.g. at the beginning of a venture or project.

• The ratio cannot be altered afterwards.

• The ratio is a simple percentage.

• The ratio is fixed on the basis of the expected profits.

• If the realized profits exceed the expectations, the capital provider receives a return on the invested capital that is higher than anticipated.

• If the realized profits fall short of the expectations, the capital provider receives a return on the invested capital that is lower than anticipated.

Most proponents of PLS financing did not deal in their models with asymmetric information, i.e. divergent ex ante profit expectations of the entrepreneur and the capital provider. However, if PLS contracts with the outlined characteristics are to be applied in a world of asymmetric information and divergent expectations, it is not too difficult to find theoretical arguments why capital providers would generally dismiss mudārabah and mushārakah financings.

The entrepreneur and the capital provider can always compare the costs of a Shariah compliant funding based on the expected profit and a negotiated profit sharing ratio on the one hand with the costs of a fixed mark-up sale(murābahah) or rent (ijārah) financing on the other hand. The mark-up rate is externally determined by market forces,


and it serves as the benchmark rate to which the profit sharing ratio has to be adjusted for a given expected profit and amount of capital. The profit sharing ratio is inversely related to the expected profit: The higher the expected profit, the lower the ratio. In the simplest case, the entrepreneur will ask for a PLS financing as long as the expected profit multiplied by the negotiated profit sharing ratio (= costs of PLS financing) is less than the mark-up multiplied by the amount of capital (= costs of mark-up financing), and the bank will offer a PLS financing if the expected profit multiplied by the negotiated profit sharing ratio (= returns of PLS financing) is larger than the mark-up multiplied by the amount of capital (= returns of mark-up financing). For a given mark-up, a specified amount of capital and identical profit expectations of the entrepreneur and the bank, there is one equilibrium profit sharing ratio on which the parties can agree.1If the realized profit falls short of the expected profit, the effective costs and returns of the PLS financing will be less than expected: This is to the advantage of the entrepreneur and to the detriment of the bank.

In a world of imperfect information, the bank has to rely largely on information provided by the entrepreneur for the formation of its profit expectations. Suppose the entrepreneur expects that his project generates a particular operating profit. If he wants to minimize the financing costs, he has a strong incentive to provide and present information about his project in such a way that the bank expects a profit that exceeds his own expectations (which he does not directly communicate to the bank). The more optimistic the bank gets, the lower is the profit sharing ratio to which it would agree in a PLS financing. If the bank overestimates the profit, i.e. if the expectations of the entrepreneur turn out to be correct, the bank’s returns will fall short of its expectations.

However, banks are aware of the information asymmetries and the incentives for entrepreneurs to present optimistic profit expectations. The bank could protect itself to some degree against too optimistic profit projections by a thorough evaluation of business plans. But that requires human resources with a profound knowledge of the markets of their customers, and the experts of the bank should, on average, be better in predicting financial outcomes of business plans than the entrepreneurs themselves. Expert staff with such a qualification is hard to find, very expensive and probably even harder to retain (because these employees have all qualities to become entrepreneurs themselves). Therefore, the bank may take recourse to a less expensive protective mechanism, namely a simple “safety margin” on all profit sharing ratios. But this will be anticipated by the entrepreneurs. If an entrepreneur presents a realistic profit projection, the “safety margin” on the bank’s profit sharing ratio will make the PLS financing more expensive than the mark-up financing. Entrepreneurs with good projects may not like to enter into the trouble of debating with the bank the credibility of their profit projections in order to eliminate the safety margin. Instead, they go for a fixed cost financing from the outset. In contrast, for entrepreneurs with weak projects the mark-up financing may be too expensive, and they have the strongest incentives to present an acceptable profit projection in order to get PLS financing from the bank. Hence, banks face an adverse selection scenario that distracts them from entering into PLS contracts.

1 A more realistic model would assume not a single expected profit but a range of expended

profits with different probabilities. The introduction of a probability distribution for expected profits would allow for multiple profit sharing ratios on which the parties could agree, and one could introduce the bargaining power of the parties to further narrow down the possible results. This would complicate the model significantly, but it would not bring fundamentally new insights.


(2) Bank manager give another answer for the lack of participatory financing. Most Islamic banks do apply the PLS principle in their deposit business. The Shariah compliant alternative for savings accounts and term deposits are so-called “unrestricted investment accounts” which are based on mudārabah contracts. The bank acts as mudarib and invests the funds of the account holders’ (rab al-mal) on their behalf. The bank receives a share of the earned profits while the remaining profit belongs to the investment account holders. Should the investment end in a capital loss, this loss has to be born exclusively by the investment account holders. A loss reduces their repayment claims against the bank.

Investment account holders are typically characterised as being risk averse, although they have signed a profit sharing and risk bearing contract. They prefer an investment policy that minimizes the risk of a capital loss. They expect from the bank that all conceivable techniques for risk mitigation and risk avoidance are applied. Islamic bankers refer to this risk aversion and justify the virtual abandonment of mudārabah or mushārakah financings with their fiduciary duties towards the risk-averse investment account holders.2

2. PLS Form and Mark-up Substance in the Capital Market: Mushārakah Sukūk While Islamic banks were very reluctant to apply PLS based modes of financing,

mushārakah became the preferred type of contract for the structuring of Shariah compliant capital market products, sukūk. At its peak in 2007, three quarters of all sukūk issued were classified as equity-based mushārakah sukūk.

This is somewhat surprising for two reasons:

• First, information asymmetries and adverse selection incentives are, in principle, not only relevant for banking but also for capital markets.

• Second, sukūk were often conceptualized as “Islamic bonds”, i.e. as Shariah compliant fixed income instruments, while a mushārakah contract as a profit sharing arrangement implies variable returns for the capital provider.

A closer look at the practice of the issuance of mudārabah and mushārakah sukūk offers a solution for this puzzle: In spite of their participatory form and their classification as “equity-based” sukūk, most of these sukūk never had a participatory substance. Instead, most of the mushārakah sukūk were intentionally structured as functional equivalents of conventional bonds, i.e. as debt instruments with predetermined returns.3 Hence, they did not suffer from the agency problems discussed in the academic literature, and capital providers earned a fixed income because fluctuations of the actual profits were smoothed out and not passed on to them (except in extreme cases). Some of the practices are outlined below.

2 The explicit purpose of a mudārabah partnership is the generation of a profit, but an

essential constraint, resulting from its fiduciary character, is that the mudarib has the duty to avoid any harm to the (capital of the) rab al-mal.

3 For a description of the practices in mushārakah and mudārabah sukūk and for case studies see Abdel-Khaleq and Crosby 2009, Kapetanovic and Becic 2009, Casey 2012, Saeed and Salah 2012, Mokhtar 2011.


While fixed returns can be structured with far less complication for debt-based sukūk such as murabahah or ijarah sukūk, “equity-based”mudārabah and mushārakah sukūk allow (in contrast to most other types of sukūk) the issuing of a security which is not tied to the true or beneficial ownership of an existing specific tangible asset. Instead, mudārabah and mushārakah sukūk create ventures for the investment of the sukūk capital in profit generating Shariah approved assets that are yet owned by the issuer when the venture is formed. The assets can be acquired with the sukūk resources, i.e. the money paid by the sukūk subscribers, and the composition of the assets held by the venture can change over the life of the sukūk. This flexibility was the main attraction for practitioners that can explain the rapid growth of mushārakah sukūk. Their popularity was not due to their equity structure which – in theory – brought them closer to the Islamic economists’ ideal of participatory finance. To the contrary, the equity elements, in particular a volatility of returns for the capital providers and the risk of a capital loss, were undesired and effectively removed by contractual engineering.

The growth of mushārakah sukūk continued as long as the prevailing engineering practices were widely accepted. This changed after 2007 when it became apparent that some provisions of mushārakah sukūk did violate Shariah requirements.

Predetermined Returns for Equity-Based Sukūk For achieving predetermined returns, sukūk engineers used at least three different

techniques:

• When actual profits fell short of expected profits, sukūk managers often provided interest-free loans (which should be recovered later) in order to meet the expectations of the sukūk holders and to beef-up the payouts to them. AAOIFI made it clear that this practice is not Shariah compliant: “It is not permissible for the Manager of Sukuk, whether the manager acts as Mudarib (investment manager), or Sharik (partner), or Wakil (agent) for investment, to undertake to offer loans to Sukuk holders, when actual earnings fall short of expected earnings. It is permissible, however, to establish a reserve account for the purpose of covering such shortfalls to the extent possible, provided the same is mentioned in the prospectus.”4

• Another technique that violates Shariah principles was applied in some mushārakah sukūk with very special purchase undertakings (PUs) which did not only guarantee the face value of the certificate at maturity, but factually also the expected profit. These PUs were not only triggered by the maturity of the sukūk but also when the venture was not performing well in one year so that the obligor failed to pay the expected profit. The exercise of the PU obliged the obligor to pay the outstanding principal plus any so far accrued but unpaid profit. Mokhtar (2011, p. 33) points out that “accrued profit is not necessarily actual profit earned. Profit accrued is the expected profit that is earned by the investors as time passes by.” Given that the prospectus indicated an expected profit accrued over the life of the sukūk, then the early redemption clause for the PU was effectively a guarantee of a (minimum) predetermined return. This converts the substance of an equity certificate into the equivalent of a conventional bond. It is obvious that this very special form of a “face value plus accrued profit PU” violates Shariah principles even more than a “plain face-value PU” at maturity.

4 AAOIFI 2008, p. 2.


• Another widely used technique for the conversion of a participatory instrument into a close equivalent of a bond with (almost) predetermined returns for the sukūk holders in “normal” years (i.e. when the mudārabah or mushārakah generates a return that meets or surpasses an articulated profit expectation as the benchmark) was based on “incentive fees”: First, the profit share of the sukūk holders is set to a maximum, e.g. 99%. Should the actual profit fall short of the expectation (benchmark), (almost) all of the profit goes to the sukūk holders. If the benchmark is set to a moderate level, this shortfall situation should be a rare exception or not materialize at all. Typically, i.e. under “normal” circumstances, the actual profit should exceed the benchmark. In these years, a second provision becomes effective: The amount of the actual profit that exceeds the benchmark is given to the sukūk manager as an incentive fee for “good management”.5 Suppose that the agreed upon expected profit is calculated on the basis of LIBOR plus a risk factor as the benchmark. Then this arrangement implies that sukūk holders will receive under “normal circumstances” the equivalent of the risk-adjusted market rate of interest.6 It is noteworthy that such a technique is in harmony with AAOIFI standards:“[I]t is permissible to agree that if the profit realised is above a certain ceiling, the profit in excess of such a ceiling belongs to a particular partner. The parties may also agree that if the profit is not over the ceiling or is below the ceiling, the distribution will be in accordance with their agreement.” [Sharīah Standard No. 12, section 3/1/5/9].

Debt Character of Equity-Based Sukūk: Capital Guarantees The debt character of equity-based sukūk was achieved by a (binding) promise of

the obligor to repurchase the sukūk certificates at maturity (or in the event of a default) at their issuing price, in respectively their face value. This eliminates contractually the risk of a capital loss of the rab al-mal, and it is a functional equivalent to the guarantee of the capital of one party by the other.7 Effectively, losses are not borne in proportion to the capital contributed to the venture, or even not borne at all by the capital providers.8 An

5 See, for example, Kapetanovic and Becic 2009 for mudārabah sukūk and Abdel-Khaleq and

Crosby 2009 and Mokhtar 2011 for mushārakah sukūk. 6 More precisely, the sukūk holders still have a downside risk since they must bear losses in

proportion to their capital share (unless they are protected by a PU at face value or a third party guarantee), and in cases of an underperformance they will receive a return less than the benchmark. On the other hand, their upside potentials are capped at the benchmark rate. This in combination does not look very attractive, but when demand exceeds supply (or risk is not taken seriously), such terms were seemingly acceptable.

7 Legally, the contracting partner of the sukūk holders is the sukūk issuer. The issuer, however, is typically a special purpose vehicle (SPV) set up by the obligor. The SPV could not survive without commercial backing of the obligor. The obligor is the legal entity (e.g. a company or a governmental institution) which receives the sukūk proceeds (i.e. is financed by the sukūk issuance) and benefits from the whole contractual arrangement. Form an economic perspective, the legally separate SPV and obligor should be taken as one commercial unit.

8 It is permissible that one party voluntarily takes on a loss once it has occurred without any obligation (i.e. without a stipulation in the sukūk contract or in a supplementing binding promise). This is backed by AAOIFI Shariah Standard No. 12, section 3/1/5/4: “It is ... valid that one partner takes, without any prior condition, the responsibility of bearing the loss at the time of the loss.”


arrangement with such a consequence can hardly meet the Shariah principle that only risk justifies return. The principle of loss sharing or loss bearing has been stated over and again - from classic legal manuals9 to contemporary AAOIFI standards (for example, Financial Accounting Standard No. 4 on mushārakah financing,10 adopted in 1996, Shariah Standard No. 5 on guarantees,11 adopted in 2001, No. 12 on sharika (mushārakah),12 adopted in 2002, and No. 17 on investment sukūk,13 adopted in 2003).

There is but one escape from the rule of loss bearing by the capital provider, namely a voluntary guarantee by a third party: “It is permissible for a third party, other than the mudarib or investment agent or one of the partners, to undertake voluntarily that he will compensate the investment losses of the party to whom the undertaking is given,

9 As an example for frequently quoted views of a classic 12th century C.E. jurist who ponders

the views of the scholars of earlier centuries, see Ibn Rushd (1996), chapters 32 and 34. For a 19th century C.E. compilation of Islamic civil law, including commercial (basically Hanafi) law, see the chapter VI of the Mejelle (n.a. 2001), dealing with partnerships by contract; see in particular paragraphs 1359, 1369 and 1403 on the distribution of losses.

10 Albeit being an accounting standard, Appendix B of this standard gives a comprehensive summary of the stipulations for a mushārakah in classic Islamic jurisprudence (fiqh) with many bibliographical references and an explication of important differences between the (Sunni) schools of law (madhhab). The following principles are stated: “Neither partner can guarantee the other partner's capital, because Musharakah is based on the principle of alghurm-bil-ghunm(the entitlement to return is related to the exposure to risk).” [Appendix B, section 1/3/1]. “Fuqaha agree that loss should be divided between the partners in proportion to their respective shares in the capital.” [Appendix B, section 1/3/4].

11 “It is not permissible to stipulate in trust (fiduciary) contracts … that a personal guarantee or pledge of security be produced, because such a stipulation is against the nature of trust (fiduciary) contracts … The prohibition against seeking a guarantee in trust contracts is more stringent in musharakah and mudaraba contracts, since it is not permitted to require from a manager in the mudaraba or the musharakah contract or an investment agent or one of the partners in these contracts to guarantee the capital, or to promise a guaranteed profit. Moreover, it is not permissible for these contracts to be marketed or operated as a guaranteed investment.” [section 2/2/1].

12 It is not permitted to stipulate that a partner in a Sharika contract guarantees the capital of another partner.” [section 3/1/4/1]. “It is a requirement that the proportions of losses borne by partners be commensurate with the proportions of their contributions to the Sharika capital. It is not permitted, therefore, to agree on holding one partner or a group of partners liable for the entire loss or liable for a percentage of loss that does not match their share of ownership in the partnership.” [3/1/5/4]. “The basis of the requirement that a partner is not liable except in cases of misconduct or negligence, and of the invalidity of a stipulation to the effect that a partner guarantees the capital of another partner, is that partnership operates on the basis of trust, and to hold a trustee liable for losses (except in the case of misconduct or negligence) is impermissible.” [Appendix B].

13 The owners of these certificates [= investment sukūk, including mushārakah sukūk] share the return as stated in the subscription prospectus and bear the losses in proportion to the certificates owned (held) by them.” [section 4/5]. “[T]he prospectus must state that each owner of a certificate participates in the profit and bears a loss in proportion to the financial value represented by his certificates.” [section 5/1/8/6]. “The prospectus must not include any statement to the effect that the issuer of the certificate accepts the liability to compensate the owner of the certificate up to the nominal value of the certificate in situations other than torts and negligence nor that he guarantees a fixed percentage of profit.” [section 5/1/8/7].


provided this guarantee is not linked in any manner to the mudaraba financing contract or investment agency contract.” [Sharīah Standard No. 5, section 7/6].14 A case study of the 2005 IDB sukūk[see Mokhtar (2011, pp. 34-35)]indicates that the criteria for the definition of a “third party” can be very formalistic and limp in economic substance. IDB had set up for its sukūk issuances the IDB Trust Services Limited in Jersey, a SPV with an authorized share capital of £10,000 and an issued share capital of £2. All the assets underlying the sukūk issuances were transferred from IDB to its SPV, and the prospectus of the 2005 sukūk advertised the fact that IDB was the unconditional and irrevocable guarantor of the sukūk issuance. The Shariah Board of IDB declared: “As it [IDB] is not the issuer of the Trust Certificates and is not a manager or participant, IDB can enter into contractual obligations which have the effect of guaranteeing the Aggregate Nominal Amount of the Trust Certificates and any Periodic Distribution Amounts in respect of the Trust Certificates.”15 Unfortunately, the Shariah resolution does not disclose whether the Shariah Board considered this decision to be in accordance with AAOIFI standards or, if not, how it would justify its dissenting position.

In November 2007 the chairman of AAOIFI’s Shariah Board criticized prevailing practices which changed the substance of mushārakah sukūk from an equity-based instrument (as it was conceived) into a functional equivalent of an interest-bearing bond,16 and in 2008 AAOIFI issued a resolution on sukūk. This resolution is a pointed summary of what was already contained in the AAOIFI standards.17 Seemingly this resolution had an impact on the sukūk market: The share of equity-based sukūk sharply dropped after 2008 and debt-based sukūk became dominant. In 2012, the share of mudārabah and mushārakah sukūk in global sukūk issuances (in US$) had declined from a peak of 75% in 2007 to 15% while murabaha and similar sale-based sukūk accounted for 65% and ijarah sukūk for 16% in 2012.18

14 “A third party may provide a guarantee to make up a loss of capital of some or all partners.

This guarantee is circumscribed with the conditions that (a) the legal capacity and financial liability of such a third party as a guarantor are independent from the Sharika contract, (b) the guarantee should neither be provided for consideration nor linked in any manner to the Sharika contract; (c) the third party guarantor should not own more than a half of the capital in the entity to be guaranteed, and (d) the guaranteed entity should not own more than a half of the capital in the entity that undertakes to provide a guarantee.” [Shariah Standard No. 12, section 3/1/4/3].

15 The fatwa is reproduced in Mokhtar 2011, 35. 16 See Usmani 2007. 17 See AAOIFI 2008. 18 Shares calculated from the figures of Zawya’s Sukuk Quarterly Bulletin, issues 13 to

16. The growing popularity of sale- and rent-based sukūk may be explained by the objectives of predetermined returns for capital providers on the one hand and undisputed Shariah compliance on the other hand. The latter reduces the Shariah non-compliance and reputational risk and enhances the marketability of the paper. After the AAOIFI intervention, debt-based structures were deemed far less risky (regarding Shariah compliance) and more marketable than equity-based sukūk which had been transformed into fixed income instruments. For longer term financings, ijārah sukūk became quite popular because AAOIFI allows for this type of sukūk a straightforward guarantee of the capital by a purchase undertaking of the issuer at face value.


II. Building blocks for “AAOIFI compliant”Mushārakah Financings and Sukūk AAOIFI did not summarize in its 2008 resolution a number of remarkable

provisions in AAOIFI standards19 which could be used as “building blocks” for the structuring of more “AAOIFI compliant” mushārakah bank financings or sukūk with equity characteristics but limitations of the downside risks for the capital providers.

As long as the bulk of sukūk are conceived as fixed-income instruments by financial institutions as the major players in the sukūk market, equity characteristics are not appreciated since they would imply some variability of returns. However, if more sukūk are issued by non-financial enterprises, the perception of equity characteristics may change, and the demand for Shariah compliant temporary equity-like instruments may increase, provided the variability of returns respectively costs and the risks of capital losses can be contained and limited to manageable dimensions. The following provisions of several AAOIFI standards could be used as building blocks for the structuring of a mushārakah bank financing or a sukūk which is not only equity-based in its legal form but to some degree also in its economic substance.

• The profit sharing formula has to be fixed at the beginning of a mudārabah or a mushārakah: “It is a requirement that the mechanism for distributing profit must be clearly known in a manner that eliminates uncertainty and any possibility of dispute.”20 The term “mechanism” allows for schemes that are more complex than simple percentages. This was also explicated in a previous standard: “It is permissible for the partners to agree on the adoption of any method of allocation of profit, either permanent or variable, for example, by agreeing that the percentages of profit shares in the first period are one set of percentages and in the second period are another set of percentages, depending on the disparity of the two periods or the magnitude of the realised profit. This is allowed provided that using such a method does not lead to the likelihood of a partner being precluded from participation in profit.”21

• Irrespective of the complexity of the initially accepted formula, it is “permissible for the parties to change the ratio of distribution of profit at any time and to define the duration for which the agreement will remain valid.”22

• The changing of the distribution scheme can even be made when the actual profit of the venture is known at the end of the life of the sukūk: “The parties may bilaterally agree to amend the percentages of profit-sharing on the date of distribution. Also, a

19 Not all rules are explicated in the Shariah standard on investment sukūk. Several have been

laid down in the standards for the underlying mushārakah or mudārabah contracts. 20 Shariah Standard No. 13, section 8/1, italics added. 21 Shariah Standard No. 12, section 3/1/5/1, italics added. 22 Shariah Standard No. 13, section 8/3, italics added. “It is permissible for the partners to

amend at any point of time the terms of a partnership contract. They may make changes to the ratio of profit-sharing, taking into account that any losses are shared according to the share of each partner in the partnership capital.” Sharī� ah Standard No. 12, section 3/1/1/4, italics added.


partner may relinquish, on the date of distribution, a part of the profit that is due to him in favour of another party.”23

• “It is permissible for the issuer or the certificate holders to adopt permissible methods of managing risk, of mitigating fluctuation of distributable profits (profit equalisation reserve), such as establishing an Islamic insurance fund with contributions of certificate holders, or by participating in Insurance (Takaful) by payment of premiums from the income of the shares of Sukuk holders or through donations (tabarru`at) made by the Sukuk holders.”24

These elements – plus the Sharīah compliant third party guarantees – facilitate, in principle, the structuring of financings or sukūk that can reconcile the main conflicting interests of capital providers and capital seeking entrepreneurs in situations where the actual performance of a project or an enterprise deviates from the initial expectations. Risk-averse capital providers may prefer a structure with predictable and stable returns and limited downside risks, while capital seeking entrepreneurs would appreciate a structure that results in some financial relief in “bad years”. This implies some risk-sharing elements in the financing arrangements. Both parties may have an interest in the sharing of upside gains, i.e. actual profits that exceed the expected profits in “good years”.

The AAOIFI tools allow corrections of an initial arrangement in the light of new developments, for example the increase of the profit sharing ratio for the capital providers if the realized profit falls short of the initially expected profit. However, there is one fundamental precondition for any adjustment, namely the explicit consent of all contracting parties.

If information asymmetries and self-interested behaviour are real world phenomena, it may be almost impossible to come to an agreement on a profit redistribution. The distribution of profits according to the initial sharing ratio differs from the initially envisaged profits due to a deviation of the realised from the expected total profits. As a consequence the cost of capital and the return on investment differ from the expected values, and this may give rise to the request for a renegotiation of the ratio. But a revised ratio implies a definite gain for one party and a definite loss for the other. It is very unlikely that contracting parties with equal bargaining power would give up profits which are legally due to them in favour of the another party, although they had initially

23 Shariah Standard No. 12, section 3/1/5/2, italics added. A readjustment of profit sharing

ratios at the day of distribution, i.e. when the distributable profit is known, is equivalent to the fixing of the distribution of the profits in absolute amounts. This might be considered Shariah compliant because the fixing of absolute amounts is not done at the beginning but at the end of the contract life. But then the final outcome of the transaction could depend more on the bargaining power of the contracting parties and less on the initial profit sharing agreement. This agreement determines the starting positions for the final negotiations on the profit distribution, but also the fallback positions if the contracting parties do not agree on a different distribution.

24 Shariah Standard No. 17, section 5/1/11. “It is permissible, based on the articles of association or a decision of the partners, not to distribute the profits of the company. It is also permissible to set aside periodically a certain ratio of profit as a solvency reserve or as a reserve for meeting losses of capital (investment risk reserve) or as a profit equalisation reserve.” Shariah Standard No. 12, section 3/1/5/14.


expected a profit distribution different from the one that was actually achieved. Divergences between expected and realized profits can not only arise at end but at any time and repeatedly during the life of a PLS contract. Hence, there could be a need for a continuous renegotiation of the profit sharing ratio in order to avoid “unfair” profit distributions.

III. PLS financing with a Self-Adjusting Profit Sharing Ratio The objective of a self-adjusting profit sharing ratio in mushārakah financings and

sukūk is to find a way out of the stalemate caused by imperfect information and self-interested behaviour, and to ensure that the future profit distribution meets fairness criteria on which the contracting parties agree ex ante, i.e. when they conclude the mushārakah contract.

It is permissible to adjust the profit-sharing ratio at any time during the life of a mudārabah or mushārakah contract by consent of the contracting parties, but it is not mandatory that this is done in a discretionary manner by negotiations on the basis of new performance information. Hence, the adjustment can be automated by a formula that links the profit sharing ratio to the actual performance (in the simplest case to the actual profit) of the financed project or venture in a way that is considered fair ex ante by the contracting parties.

To calculate a performance-dependent profit sharing ratio for a mushārakah structure, it must be known how much capital is provided externally by a bank or by sukūk holders and how much is provided internally by the enterprise itself. At the beginning of the joint venture, a certain total profit is expected which has to be distributed to the external and the internal capital providers. The profit sharing ratio denotes the share of profit allocated to the external capital providers. This profit sharing ratio will not be fixed directly as a number. Instead the number is computed by a formula on which the parties have agreed. This formula is based on a distribution pattern for the profits on which the contracting parties have reached a consensus. It could, for example, be a fixed relation between the rate of return for the external and for the internal capital, or it could tie one of the rates of return to an external benchmark. The distribution pattern – i.e. the relation between the rates of return for external and internal capital or the link of one rate of return to a benchmark – is fixed at the beginning of the joint venture, and the corresponding profit sharing formula will be applied afterwards. The formula will re-calculate the profit sharing ratios whenever new information on expected profits becomes available. The repeated re-calculations on the basis of the most recent performance information (= information on the expected profit) ensure that the agreed distribution pattern will be maintained throughout the life of the mushārakah contract.

A structure in which only ratios as such or a formula for the calculation of ratios are determined does not fix ex ante the absolute amount of the profit (in terms of the respective currency) for the contracting partners. It only determines the relative positions of the parties. The absolute amounts depend on the finally realised profits which are only known at the end of the contract. To keep the relative positions of the parties in the agreed-upon proportion, the profit sharing ratio is adjusted. A respective formula is outlined below in its simplest form. For the computation of the adjustable profit sharing ratio, the following variables are used:


Ke = external capital (provided by the bank or the sukūk holders)

Ki = internal capital (provided by the entrepreneur)

K = Ke + Ki = total capital

P = total distributable profit

Pe = s ·P = profit allocated to the external capital

Pi = (1 – s) P = profit allocated to the internal capital

s = Pe/P = profit sharing ratio = share of total profits allocated to the external capital

β = benchmark rate of return

re = Pe/Ke = rate of return for external capital

ri = Pi/Ki = rate of return for internal capital

r = p/K = rate of return on total capital

Next, an “objective function” has to be defined. The contracting parties may discuss various alternatives. For example, they may consider it as a fair distribution that both parties achieve the same rate on return on their invested capital. A variant of this approach could be to give one party a predetermined bonus over the share of the other partner (for example, as a compensation for management efforts). Another plausible scenario could be that the provider of the external capital prefers a profit distribution which reduces the volatility of his own profit share and gives him a more stable revenue stream that meets a certain benchmark, for example the return from an investment in fixed-income securities (such as ijārah sukūk); exceeding profits will remain with the other party in good years, the value of its profit share would be reduced in bad years. The simple model outlined below indicates, inter alia, that the distribution parameters could also be calibrated with respect to leverage effects of external capital (provided the parties agree on such a pattern). These are only a few examples for a wide range of conceivable arrangements for the reconciliation of the revealed preferences and interests of the contracting parties in a participatory finance setting such as a mushārakah sukūk or bank financing. The preferences and interests are contractually recorded and translated into a structure which protects the distributional preferences of the contracting parties by automatic alignments of the distribution parameters (in particular the profit sharing ratio) whenever new performance information of the project or joint venture become available. The automatic adjustment obviates the need for ex post re-negotiations on redistribution which are permissible according to AAOIFI, but very difficult to realise when the gains of one party are the losses of the other party.25

The following is an illustration of the basic mechanism underlying the idea of an adjustable profit sharing ratio. Assume that the contracting parties had agreed on one of the following distribution rules (“objective functions” in the model):

25 For medium to longer term mushārakah financing, the ex ante negotiations on an adjustable

profit allocation mechanism are somewhat similar in their effects to the hypothetical “veil of ignorance” of John Rawls behind which even “egoistic” individuals could come to a consensus on rules for a “just” or “fair” distribution.


The profit sharing ratio should be such that either

(1) the return on external capital is equal to the return on total capital, or

(2) the return on external capital is the same as the return on internal capital, or

(3) the return on external capital equates the benchmark β, or

(4) the return on internal capital is a multiple or fraction α of the return on external capital.

The appropriate profit sharing ratios are determined as follows:

Cases (1) and (2), profit sharing ratio for

re = ri = r:26

Case (3), profit sharing ratio for re = β:

Case (4), profit sharing ratio for ri = α·re:

A numerical example is given in the appendix. It illustrates the influence of

different benchmarks, of a surcharge on the relative return for one party, and of different (actual or expected) profits. The table does not change the relation between external and internal capital, but the relevance of the capital structure is clearly visible from the profit sharing formulas above.

The above sample did explain the basic mechanism of the model only for very simple objective functions. In practice, contracting parties might agree on more complex formulas (for example, with caps or equivalents of “incentive fees”).27

It is clear that the profit sharing mechanism will only work as long as profits are generated. It does not provide an effective protection against the need of “loss sharing” in an individual mushārakah setting. In the interest of risk mitigation and loss avoidance, the capital provider should diversify investments by financing not only one entrepreneur but a number of firms in different markets with uncorrelated market trends, and he may also invest some funds in risk-minimized fixed-return instruments. But risk management in Islamic finance in general is a topic which lies beyond the scope of this paper. 26 Cases (1) and (2) are identical:

27 Admittedly, it would also be possible to define an objective function in such a way that one

party receives a fixed amount as profit share (provided the volume of the total profit is at least as large as the fixed amount) – which would not be permitted under Shariah. But discretionary re-negotiations can achieve the same result. Insofar the automated system is not better or worse than discretionary practices regarding a possible “misuse”.


The idea of a variable profit sharing ratio can also be found in a paper of Diaw, Bacha and Lahsasna (2012). But their perspective is a theoretical analysis and not the outline of an implementable recommendation for contracting parties in a mushārakah structure. They present a general equation that indicates the directions in which different parameters influence the profit sharing ratio. They do not transform their general equation in such a way that it would become an objective function and could be used (after calibration) in negotiations on a distribution pattern. Instead, Diaw, Bacha and Lahsasna present a Monte Carlo simulation which gives a feeling for implied dependencies and possible dynamics. They do not integrate changes of the expected (or actual) profit into their analysis.

Islamic economists have repeatedly made attempts to overcome agency problems in participatory finance in order to make them more acceptable to market participants, in particular to providers of funds.28 This is because many see participatory finance as the ideal form of Islamic finance and as the core element of a genuine Islamic financial system. Even if one would not go that far, participatory modes of finance such as mudārabah or mushārakah could fill a gap, for example, in the start-up and growth financing of SMEs. In general, participatory finance gives entrepreneurs some financial relief in times of an unexpectedly poor performance of their business. This risk-reduction can enhance their willingness and ability to ramp up innovations (new products, processes or technologies) or to enter into new markets. This should not only generate private profits but also social benefits in terms of employment and income opportunities. The model presented here outlines a technique which could make participatory modes of financing more attractive to financiers as well as entrepreneurs seeking finance.

IV. Conclusion AAOIFI has allowed a remarkable wide range of “corrective measures” in

mudārabah and mushārakah contracts which are deemed Shariah compliant: The contracting parties can re-negotiate factually all commercially relevant aspects of their contracts at any time. A main reason for such re-negotiations is new information about the performance (profit) of the financed project or venture. The crux of re-negotiations is that they will be successful only if one party is willing to transfer financial gains to the other party. Such a voluntary redistribution is not very likely.

The proposal of a self-adjusting profit sharing ratio obviates the need for discretionary re-negotiations. It uses elements of the AAOIFI toolbox to structure a contractual arrangement that maintains the distribution pattern which was initially agreed upon by the contracting parties. It does so by an automatic adjustment of the profit sharing ratio whenever new information on the expected profit becomes available. It can be calibrated such that the risk aversion of the financier can be factored in. A mushārakah contract with a self-adjusting profit sharing ratio is incentive compatible insofar as it does not provide incentives for profit compression by under reporting, by allocation of fixed costs to the financed project, by fringe benefits, or by shifting profits into periods after the termination of the mushārakah contract.

For the financed entrepreneur it is beneficial that a participatory financing implies a kind of “embedded” insurance against unexpected downside risks (loss sharing). However, the loss absorbing qualities of a mudārabah or mushārakah contract will not come for free but will be reflected in the costs of funds (e.g. by a risk premium added to a benchmark rate by the financier). On the other hand, the contract can be calibrated such

28 See in particular Bacha 1979, Ahmed 2002, and Hasan 2002.


that both parties can enjoy upside gains. This is in contrast to the widespread practice of a complete skimming off of gains by one party in mushārakah sukūk.

It is obvious that arrangements based on self-adjusting profit sharing ratios are no “pure” PLS arrangements as envisaged in early contributions of Islamic economists. The adjustments of the profit sharing ratio moderates the effectiveness of the PLS principle, and they insert features of fixed income instruments into the arrangement. Insofar the approach may not be the first best solution in an ideal world. But in a real world with information asymmetries and self-oriented actors, first best models do not work, and the economic and Shariah shortcomings or merits of the approach should be discussed in relation to other real world proposals to overcome the inherent agency and adverse selection problems of PLS arrangements.


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http://www.muftitaqiusmani.com/images/stories/downloads/pdf/sukuk.pdf.


Withdrawal Behavior of Malaysian Islamic Bank Customers: Empirical Evidence from

Three Major Issues By

Muhamad Abduh*

Abstract As interest is prohibited, the reliance of Islamic banking towards bank deposits from depositors is higher than conventional banking. Efforts that could help in preventing funds withdrawal by the depositors thus become necessary in order to avoid bank instability. This study is aimed at investigating factors that may influence the withdrawal behavior of Malaysian Islamic banks customers. The withdrawal behavior studied here is in conjunction with three major issues which are (i) issues of non-shariah compliance, (ii) lower returns as compared to other banks, and (iii) rumors about forthcoming financial crisis that may affect the performance of the bank. The research employed a direct survey through a self-administered questionnaire handed out to Islamic banks customers in Malaysia using the multi-stage sampling technique. The intention to avoid interest, type of account, working status, bank status, and bank ownership are the significant factors that could influence withdrawal behavior in model 1. Working status and bank ownership are the factors which influence withdrawal behavior in model 2. Lastly, for model 3, factors that emerged to be significant are type of account, total deposit in bank, awareness on deposit insurance, intention to avoid interest and perception that Islamic banks are less affected by the crisis.

Keywords: Islamic bank, withdrawal behavior, consumer behavior, Malaysia

1. Introduction At its inception, the creation of a bank is aimed to serve as an intermediary

financial institution which effectively and efficiently connects the surplus group to the deficit groups in order to support the economic activities and growth through effective allocation of resources. Liquidity availability however is indispensable for banks to

* Author: Muhamad Abduh, PhD, is a head of Research IIUM, Institute of Islamic Banking and

Finance (IIiBF), International Islamic University Malaysia. E-Mail: [email protected]


increase and deepen its financial intermediary activities so as to significantly contribute to the development of the economy. Nonetheless, reliance on the shareholders’ money per se is obviously insufficient. As such, banks need to attract money from group of people with surplus in the form of deposits. The money collected can then be mobilised for loans or financing activities for people from the deficit group in order to promote productivity and economic growth.

In fact, in the case of Islamic banking, Abduh et al. (2011) explained that since interest is forbidden in Islam, the flexibility of Islamic banks in obtaining funds to cover their expenses and financing is limited. For that reason, deposits are even more important for Islamic banks compared to conventional banks. Consequently, to maintain their stability, serious attention towards factors affecting fluctuation in total deposits become imperative for Islamic banks.

There are studies like Haron and Ahmad (2000), Haron and Azmi (2008), Kasim et al. (2009), Kasri and Kasim (2009), and Abduh et al. (2011) which had utilized econometrics models to uncover the relationship between the fluctuation of the total deposit in Islamic banking with the macroeconomic and industry specific variables. However, those studies had neglected the role of the customers as the main player in Islamic banking industry. The customers become so important because the fluctuation of the total deposits solely relies upon their final decision either to withdraw or not to withdraw when they encounter unpleasant situations.

Therefore, this study differs from previous studies mentioned above in the sense that it does not utilize macroeconomic nor industry specific variables. It explores the role of individual factors of the customers towards their decision, to or not to withdraw their deposits when they encounter three major issues i.e. (i) issues of non-shariah compliance, (ii) lower returns as compared to other banks, and (iii) rumors of a financial crisis that may affect the bank in the near future. Thus, the main objective of this study is to examine the effects of individual factors or characteristics upon the intention of deposit withdrawal.

2. Literature Review According to Bolton and Bronkhurst (1995), the definition of switching behavior is

the decision of a customer to stop purchasing particular services or patronizing the service completely. To date, the term switching behavior is used interchangeably with withdrawal behavior. However, Ahmed (2002) argued that the term withdrawal behavior is more appropriate to be used in Islamic banking framework due to the fact that Islamic banking has two types of customers - those who have Islamic bank account only and those who have Islamic and conventional accounts at the same time. For those customers with Islamic banking account only, switching to conventional banks is not an option as it against their faith, and thus the term withdrawal behavior is better to be used here. One of the common scenarios of withdrawal behavior in Islamic banking is that when customers found failure of Islamic banks to generate enough income that at least matches the level of interest rate in conventional banks and service charges are too high, they withdraw their funds which result in the decrement of the total deposits (Ismal, 2011).

The discussion of switching behavior is pioneered by Keaveney (1995) who then created a model which contained eight switching incidents. Those incidents are pricing, inconvenience, core service failures, service encounter failures, employee responses to


service failures, attraction by competitors, ethical problems, and involuntary switching plus seldom-mentioned incidents. Other studies, such as Colgate et al. (1996), Colgate and Hedge (2001) and Gerard and Cunningham (2004) have shown reasons why their respondents switched between banks. For instance, instead of having all eight factors to be significant, Colgate and Hedge (2001) and Gerard and Cunningham (2004) found that only pricing, service failures, and inconvenience are the significant factors which cause customers to switch between banks.

While numerous studies have been done in switching behavior area, the number of studies in withdrawal behavior is still limited. Ahmed (2002) and Ahmed (2003) are amongst the first studies in the area of depositors’ withdrawal behavior in Islamic banking. Similar to what has been explained by Currie (2004) in the case of conventional banks, their findings indicated that, lower rate of return and higher service charges are the main factors that drive customers to withdraw their funds from Islamic banks. Ahmed (2003) added that other factors which were considered important in influencing withdrawal behavior of Islamic banks’ customers are rumors regarding poor performance of the banks, issues related to violation of Shariah compliance procedures, and involvement in interest based income.

Abduh (2011) conducted a direct survey toward Islamic bank customers using self-administered questionnaires in Jakarta, Indonesia. Using modified SERVQUAL model and importance-performance analysis, the study concluded that Islamic bank customers are likely to withdraw their fund and if possible switch to other banks when they are not satisfy with the performance of the most important dimensions of Islamic bank service quality namely: shariah-aspect, tangible, and reliability.

Due to the customers’ intention to protect the real value of their assets, there is withdrawal possibility in situation whereby Islamic banks are experiencing lower rate of return (Ahmed, 2002). Currie (2004) and Ismal (2011) had confirmed the importance of this aspect. However, Ahmed (2003) and Abduh (2011) provided evidence that lower rate of return is not the only cause of withdrawal action. There is also higher likelihood of customers to withdraw when there is a core service failure such as violation in Shariah principles in products and services. Since Shariah compliance is the main characteristic that differentiate Islamic banks from its conventional counterparts, this finding is also in line with the conclusion from Zang et al (2007). Lastly, Lambert and Simon(2000), Takemura and Kozu(2009) and Yada et al (2009) found that rumors in the media relating to financial or banking crisis could also trigger customers to withdraw their money.

Therefore, for an Islamic bank to be able to maintain a stable and sound condition, the implementation of risk analysis and risk management are necessary, particularly with regard to deposit withdrawal risk. One of the best ways to mitigate withdrawal risk is by having information about customers’ withdrawal behavior.

In view of what has been discussed in the literatures, this study focuses on three important aspects of what can cause withdrawal action which are Shariah non-compliant issues (Ahmed, 2003; Zang et al, 2007; Abduh, 2011), lower rate of return (Ahmed, 2002; Currie, 2004; Ismal, 2011) and rumors about financial/banking crisis happening in the near future that may affect the bank (Lambert and Simon, 2000; Takemura and Kozu, 2009; Yada et al, 2009).

This study differs from previous studies such that it uses three different aspects resulted from previous studies as the situation which could trigger the withdrawal action


by Islamic bank customers. Afterwards, it examines the individual factors that may influence the respondent’s withdrawal behavior under those three situations. Therefore, the following research questions (RQ) are developed:

RQ1: What factors could influence the customers to withdraw their deposits when they encounter Shariah non-compliance issues?

RQ2: What factors could influence the customers to withdraw their deposits when they receive lower rate of return?

RQ3: What factors could influence the customers to withdraw their deposits when they hear rumors about financial/banking crisis happening in the near future that may affect the bank?

3. Data and RESEARCH Method

3.1 Data Data used in this study are obtained from Islamic bank customers through a self-

administered questionnaire. In total, 450 questionnaires were distributed to the respondents; however, after selecting those questionnaires that are properly filled, this study eventually uses data from 368 respondents.

Table 1: Dependent Variables in Binary Logit Model Variable Description Response Y1 My Islamic bank is found to be practicing non-Shariah

compliance products and services. 1 = I will withdraw 0 = I will not withdraw

Y2 Uncompetitive rate of return given by my Islamic bank 1 = I will withdraw 0 = I will not withdraw

Y3 There are rumors that a banking crisis will happen in the near future and I worry that my Islamic bank will be affected

1 = I will withdraw 0 = I will not withdraw

3.2 Variables

This study aims to uncover the individual factors that may lead Islamic bank customers to withdraw their money due to: (i) non-Shariah compliance related issues, (ii) a lower rate of return compared with other Islamic banks and conventional banks, and (iii) rumors that a banking crisis will occur in the near future that may affect the bank. The explanations of the dependent and independent variables are provided in table 1 and table 2 respectively.

Table 2: Independent Variables in Binary Logit Model

X1 : Type of account (1 = Investment account; 0 = Otherwise) X2 : Amount of money deposited (1 = more than RM10 thousands; 0 = Otherwise) X3 : Time period of being an Islamic bank customer (1 = 3 years and above; 0 =

Otherwise) X4 : Working status (1 = an employee; 0 = Otherwise) X5 : Using internet banking (1 = Yes; 0 = No) X6 : Bank status (1 = Full-fledged; 0 = Subsidiary)


X7 : Bank ownership (1 = Local; 0 = Foreign) X8 : Having an account in conventional bank (1 = Yes; 0 = No) X9 : For those who have account in conventional bank, which statement is true?

(1 = Most of my money deposited in conventional bank; 0 = Otherwise) X10 : Awareness upon deposit insurance (1 = Aware; 0 = Not aware) X11 : Competitive rate of return is the main reason in patronizing with an Islamic

bank? (1 = Yes; 0 = No) X12 : To avoid bank interest is the main reason in patronizing an Islamic bank?

(1 = Yes; 0 = No) X13 : Believing that Islamic banks are less affected towards banking crisis is the main

reason in patronizing an Islamic bank? (1 = Yes; 0 = No) 3.3 Logistic Regression

Regression analysis (OLS) has become an important method of inferential statistics used with any data analysis that seek to describe the relationship between a response variable and one or more explanatory variables. Extant researches employed this technique either as an analytical tool to cut into pieces the cake of data or to develop a new advanced technique based upon OLS ideas and therefore can be applied in a particular circumstance.

Amongst the techniques developed under the regression analysis framework is logistic regression. Hosmer and Lemeshow (2000) and Studenmund (2006) enlightened what distinguishes a logistic regression model from the OLS model. The outcome variable in logistic regression is binary or dichotomous, whereas in OLS, it is a continuous numerical data. It is an estimation technique suitable for equations with dummy dependent variables that avoids the unboundedness problem of the linear probability model by using a variant of the cumulative logistic function.

3.4 Model specification There are a number of distribution models that are suggested to be used in the

analysis of a dichotomous dependent variable. However, the logistic model is the most widely used by researchers worldwide. Hosmerand Lemeshow (2000) mentioned two primary reasons for choosing the logistic distribution. Firstly, from a mathematical point of view, it is an extremely flexible and easily used function. Secondly, it lends itself to a clinically meaningful interpretation.

In linear regression, it is assumed that the mean may be expressed as a linear equation in x (or some transformation of x or Y), such as

xxYE 10)|( ββ += (1)

This expression shows that it is possible for )|( xYE to take any value as x ranges between -∞ and +∞. However, in the logistic regression model, the specific model used is:

x

x

eexxYE

10

10

1)()|( ββ

ββ

π +

+

+==

(2)

where, e = euler’s number (2.7183)

πx = function of x in logit model


And in order to give a meaningful interpretation, )|( xYE is transformed with logit transformation to become:

xx

xxg 10)(1)(ln)( ββ

ππ

+=⎥⎦

⎤⎢⎣

⎡−

= (3)

The significance of this transformation is that )( xg now has many of the desirable properties of a linear regression model. The logit, )( xg is now linear to its parameter. Hence, the relationship of dependent – independent variables in this study is expressed in the following equations:

])...[1/(]...exp[ 1313221113132211 xbxbxbaxbxbxbap +++++++++= (4)

13132211 ...)1/log( xbxbxbapp ++++=− (5)

3.5 Fitting the Logistic Regression Model In linear regression, the method used most often for estimating unknown

parameters is the least squares method. In that method, concisely, values of 0β and 1β which minimize the sum of squared deviations of the observed values of Y from the predicted values based upon the model are selected. It is proven that the least squares method produces estimators with a number of desirable statistical properties. Unfortunately, this does not work with a dichotomous outcome model.

In a model with a dichotomous response as the dependent variable, the Maximum Likelihood Estimation (MLE) is used. The difference is that, while the least squares method seeks to minimize the sum of squared distances of the data points to the regression line, the MLE method seeks to maximize the log-likelihood. This MLE method reflects on how likely are the observed values of the dependent and may be predicted from the observed values of the independents.

Since likelihood is a probability, its values vary from 0 to 1. The log-likelihood is the log of the probability and its value varies from 0 to minus infinity because the log of any number less than 1 is negative. The log-likelihood is calculated through iteration, using the maximum likelihood estimation (Garson, 2010). The log-likelihood tests the significance of the researcher's model as a whole. In presenting information on the log-likelihood, statistical packages usually present not the log-likelihood itself but the log-likelihood multiplied by -2. The reason for this is that, the log-likelihood approximately has a Chi-square distribution when multiplied by -2 (Menard, 1995). A finding that is significant leads to the rejection of the null hypothesis which states that, all of the predictor effects are zero. In other words, if this likelihood test is significant, at least one of the predictors is significantly related to the dependent variable.

In assessing the significance of the independent variables that can be included in the model, the guiding principle is to compare observed values of the response variable to predicted values obtained from models with and without the variable question (Hosmer and Lemeshow, 2000).

⎥⎦

⎤⎢⎣

⎡−−−

−−−−=

)var()var(ln2

iablethewithlikelihoodiablethewithoutlikelihoodG

(6)


A non-significant likelihood ratio test indicates no difference between the full and the reduced models. Hence, it will justify the dropping of the given variable in order to have a thriftier model that works just as well. On the other hand, for the significant variables, the larger the chi-square value, the greater the loss of model fit if that term is dropped (Garson, 2010).

Table 3: Descriptive Statistics of Demography and Independent Variables

Possessing Conventional Account No (n=142) Yes (n=226) Variable Category

Freq. % Freq. % Total

Female 88 40.93 127 59.07 215 Gender

Male 54 35.29 99 64.71 153 <=35y 117 41.34 166 58.66 283

Age >35y 25 29.41 60 70.59 85 Not Married 92 46.94 104 53.06 196

Marital Married 50 29.07 122 70.93 172 Diploma and below 17 27.87 44 72.13 61 Undergraduate 26 35.62 47 64.38 73 Level of Education Postgraduate 99 42.31 135 57.69 234 Non-employee 75 44.38 94 55.62 169

Working Status Employee 67 33.67 132 66.33 199 < RM1000 49 47.12 55 52.88 104 RM1000 – RM5000 75 39.68 114 60.32 189 RM5001 – RM10,000 11 21.57 40 78.43 51 RM10,001 – RM20,000 6 40.00 9 60.00 15

Income

> RM20,000 1 11.11 8 88.89 9 < = 3 years 71 44.10 90 55.90 161 Period of patronizing

Islamic bank > 3 years 71 34.30 136 65.70 207 Subsidiary 47 34.56 89 65.44 136

Bank’s Status Full-fledged 95 40.95 137 59.05 232 Foreign 23 34.85 43 65.15 66

Bank’s Ownership Local 119 39.40 183 60.60 302 Don't know 65 41.67 91 58.33 156

Deposit Insurance Know 77 36.32 135 63.68 212 More than once per-month 96 37.21 162 62.79 258 Interaction with

patronized bank Once every month 46 41.82 64 58.18 110 Don't use 100 40.98 144 59.02 244

Internet Banking Use 42 33.87 82 66.13 124


4. Results 4.1 Descriptive Statistic

The total number of questionnaires involved in this analysis is 368 with a distribution of 215 (58.43%) and 153 (41.57%) for female and male respondents respectively. As many as 283 (76.9%) respondents are young-potential customers with the age of 35 years and below while the remaining 85 (23.1%) respondents are customers whose age is above 35 years. Meanwhile, 196 (53.26%) of the respondents are married and 172 (46.73%) aren’t. In terms of level of education, most of respondents are postgraduate degree holders (63.58%), followed by undergraduate degree holders (19.84%) and diploma degree holder or below being the least represented (16.58%).

Besides, Table 3 above shows that low and middle income individuals dominate the number of respondents in this study. About 104 (28.26%) of the respondents are people with an average monthly income of below RM1000 and 189 (51.36%) of the respondents are people with an average monthly income within the range of RM1000 to RM5000. Only 20 percent from the total respondents possess an average monthly income above RM5000.

In the present banking system, deposit insurance is one of the important features of all banks. It covers up to a certain amount of deposit money to be paid back to customers if their respective banks go bankrupt. Although this is a very important matter in the current banking system, however not every customer is well-informed about the details of deposit insurance i.e. total deposit covered and claim mechanisms. In this study, only 212 (57.61%) respondents are aware about deposit insurance, while the remaining 156 (42.39%) respondents are the opposite.

With regard to the intensity of interaction with their respective Islamic banks, as many as 258 (70.11%) respondents interact more than once every month on average while another 110 (29.89%) interact only once in every month. In addition, only few of the customers use the internet banking facility. Only 124 (33.69%) respondents respond positively, while the remaining 244 (66.31%) respondents respond negatively.

4.2 Logit Models 4.2.1 Model 1: Shariah Non-compliant

For Model 1 where Y1 is non-Shariah compliance, the significant predictors are type of account X1(1), working status X4(1), bank status X6(1), bank ownership X7(1), and the main reason of patronizing Islamic bank is to avoid ribaX12(1). In addition, its Nagelkerke R-Square is 0.57, its Hosmer-Lemeshow Test is 8.49, and its classification is 88.7% correct. The Nagelkerke R-Square is similar to the R-square in OLS and it indicates that 57% of variation in Y1 can be explained by the predictors. The Hosmer-Lemeshow test is like the F-test in ANOVA of regression, which is to measure the goodness of fit of the overall model. The null hypothesis of the Hosmer-Lemeshow test is that ‘the model fits the data’. Therefore, since the Hosmer-Lemeshow statistics is not significant, it can be concluded that the hypothesis of ‘model fits the data’ cannot be rejected statistically. In term of the result of classification, it can be said that, by using the significant predictors, discriminating methods developed by the logit model can classify the variation in Y1 correctly as high as 88.7%, which can be considered as very good.


4.2.2 Model 2: Uncompetitive Rate of Return In Model 2, only working status (X4) and bank ownership (X7) are significantly

affecting withdrawal behavior due to uncompetitive rate of returns. Positive relationship of X4(1) denotes that employees have a tendency to withdraw their fund from Islamic banks due to an uncompetitive rate of return as compared to non-employees. This is consistent with the findings in previous models that show a negative relationship of employee (X4(1)) with Shariah-compliant related issues (Y1).

The Nagelkerke R-Square of 0.209 indicates that 20.9 percent of variation in Y2 can be explained by the model. The Hosmer-Lemeshow goodness of fit test of 12.185 indicates that the model is acceptable. With regard to the classification method, Model 2 can classify 71.8% of observations correctly.

4.2.3 Model 3: Rumor about Banking Crisis in the Near Future that will affect the Islamic bank From Table 4, there are five explanatory variables that are significant in model 3

i.e. type of account (X1), total deposits (X2), awareness on deposit insurance (X10), reason is “to avoid riba” (X12) and reason is “Islamic bank is less affected by banking crisis” (X13). Estimated coefficient for X1(1), X10(1), X12(1) and X13(1) is negatively correlated with Y3 which indicates that the reference category of these variables will reduce the log-odds of the model.

The model fit measurement indicates that the model fits the data and approximately 71.5 percent of variation in Y3 can be explained by the model. Moreover, 86.6 percent of the observations can be classified correctly, which is a very good classification process.

Table 4: Estimated Coefficients (β) and Odd-ratios (Exp(β)) for All Logit models

Y1 = Non-Shariah compliance

(1 = will withdraw)

Y2 = Uncompetitive Rate of Return

(1 = will withdraw)

Y3 = Rumor about Banking

Crisis (1 = will withdraw)

Variable

β Exp(β) β Exp(β) β Exp(β) X1(1) (Investment acc.) 2.55** 12.82 -0.53 0.59 -1.96* 0.14 X2(1) (deposit > RM 10K) -0.37 0.69 0.73 2.08 2.28* 9.79 X3(1) (IB cust. > 3 years) -0.58 0.56 -0.06 0.94 0.78 2.19 X4(1) (Employee) -2.25** 0.09 1.54*** 4.66 0.13 1.14 X5(1) (Use Internet Banking) 1.35 3.87 0.47 1.61 0.06 1.06 X6(1) (Full-fledged IB) 4.20*** 66.75 -0.35 0.71 -1.08 0.34 X7(1) (Local IB) 3.62*** 37.16 -0.97* 0.38 -0.76 0.47 X10(1) (Aware Deposit Ins.) N/A N/A N/A N/A -4.58*** 0.01 X11(1) (Main reason: return) 0.09 1.10 0.12 1.12 0.19 1.20 X12(1) (Main reason: no Riba) 1.56** 4.74 -0.29 0.75 -1.27** 0.28 X13(1) (Main reason: less affected by banking crisis) 0.19 1.22 -0.18 0.84 -1.83*** 0.16

Nagelkerke R-Square 0.57 0.209 0.715 Hosmer-Lemeshow Test (Chi-Square) 8.49 12.185 5.298 Correctly Classified (%) 88.7 71.8 86.6 Note. * significant at alpha 10%; ** significant at alpha 5%; *** significant at alpha 1%.

IB = Islamic Banking.


5. Discussion From the descriptive analysis results, it is believed that the respondents are well

familiar with Islamic banking and they may have already possessed basic knowledge on Islamic banking principles and products. This is due to the fact that most of the respondents are already customers of Islamic banks for more than three years (56.25%). About half of the respondents patronized full-fledged Islamic banks and 82 percent of the respondents had chosen local Islamic banks instead of foreign Islamic banks. This, somehow, shows that people are trying to support their local bank to grow and develop particularly in term of assets size.

For Model 1, the directions of relationships between dependent and significant independent variables reveal quite an interesting result. For X1(1), investment account holders tend to make a withdrawal with a probability of 12.82 times higher as compared to non-investment account holders e.g. saving account. This indicates that investment account holders are really concerned about the Shariah-compliance of their investments and any breach committed by bank will destroy their trust, thus motivating them to withdraw their funds. Variables X6(1), X7(1) and X12(1) also significantly influence the withdrawal behavior in Model 1 positively. This indicates that customers who consider avoiding riba, patronizing full-fledged Islamic banks, and choose local Islamic banks will have higher probability to withdraw their money when their Islamic banks breach Shariah principles as compared to customers that have opposite characteristics. These findings support the results found by Ahmed (2003) and Abduh (2011).

Negative relationship for X4(1) will reduce the log-odds of the model. In term of the odds ratio of 0.09, it indicates that the probability of employees to withdraw because of the violation of Shariah principles is only 0.09 as compared to non-employee customers. In other words, the probability of non-employee customers to withdraw due to this situation is 11 (i.e. 1/0.09) times greater than employees.

In Model 2, negative and significant relationship between X7(1) and Y2 shows that local Islamic bank customers have less probability to withdraw if the Islamic bank that they patronize cannot give them a competitive return for several periods. The probability of foreign Islamic bank customers to withdraw is 2.63 (i.e. 1/0.38) times compared to local Islamic bank customers. The reason for this is perhaps due to people who had patronized foreign Islamic banks assumed that foreign banks are more stable, thus resulting in them to expect a higher return as compared to local Islamic banks. However, when they realized that their bank could not fulfill their expectation for certain periods they would rather move to other banks instead of staying with the current bank. This result supports findings from Ahmed (2002), Currie (2004), and Ismal (2011). Lastly, Model 3 presents the result for X1(1) which indicates that those with investment accounts are more reluctant to withdraw deposits due to the rumor of banking crisis that may affect the respective Islamic bank. In contrast, the likelihood of other account holders (e.g. savings account) to withdraw due to this rumor is 7.14 (i.e. 1/0.14) times greater as compared to investment account holders. A similar relationship applies to X10(1), X12(1) and X13(1). Customers who are not aware of deposit insurance (X10) have a probability to withdraw in equivalent of 100 (i.e. 1/0.01) times greater than those who are aware about deposit insurance. This result supports findings from Lambert and Simon (2000), Takemura and Kozu (2009), and Yada et al (2009). It will also strengthen the argument that media can significantly influence someone’s decision when they have not enough information or awareness regarding the issue.


Customers who attempt to avoid bank interest (X12(1)) as well as those who indicated ‘less affected by banking crisis’ as their main reason in patronizing Islamic bank (X13(1)) also have less probability to withdraw because of the banking crisis rumors. However, as anticipated, large fund customers (X2(1)) have a greater possibility to withdraw as compared to small fund customers of up to almost 10 times. One of the implications from these results is that Islamic banks and regulators should have educational and awareness program for the public on certain issues, particularly the issue of Islamic banking resilient towards banking crisis. Other important issues such as the similarities and dissimilarities between Islamic and conventional banks, basic intention of the Islamic contracts, and deposit insurance are also necessary to be informed to the public.

6. Conclusion This study discusses factors affecting withdrawal behavior of Islamic bank

customers based on the logistic regression model framework for three different dependent variables i.e. non Shariah compliance, uncompetitive returns, and rumor on a banking crisis happening in the near future that will affect the bank.

Model 1 confirms that intention to avoid bank interest (X12), type of account (X1), working status (X4), bank status (X6) and bank ownership (X7) are the factors that influence withdrawal behavior due to violation in Shariah principles by the bank. In Model 2, only the working status (X4) and bank ownership (X7) are significantly affecting withdrawal decision of the customers. Lastly, for Model 3, type of account (X1), total deposit in bank (X2), awareness on deposit insurance (X10), intention to avoid bank interest (X12) and perceiving that Islamic banks are less affected by banking crisis (X13) are the significant factors influencing withdrawal decision of the customers. As a contribution, these models can be used by bankers and academia to predict the withdrawal probability of one Islamic bank customer by collecting the required information in the model.

As a limitation of this study, it incorporates only individual customers who have an Islamic banking account only. Therefore, in order to enhance the analysis, suggestions for future researches are: (i) to include the corporate customers and (ii) those who have accounts in Islamic as well as conventional banks.

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Role of Islamic Banks in Energy Finance in Pakistan

By Salman Ahmed Shaikh29

Abstract Energy crisis in Pakistan has worsened in recent years leading to loss of output, increased incidence of manufacturing unemployment, cost push inflation, capital flight, low manufacturing capacity utilization and loss of export markets. The contributing factors to the crisis include inefficient energy mix, price distortions and low investment in alternate energy. The short term measure by the government to absorb loss from price distortions created by an inefficient energy mix has resulted in ballooning fiscal deficit. One important piece of solution lies in increased availability of financing for energy infrastructure. In this paper, we analyze the role of Islamic banks in fulfilling this need. Islamic banking in Pakistan has exhibited exceptional success in terms of assets growth. Within 10 years, the niche market now comprises almost 10% of the overall banking sector. However, questions are still raised about its differential economic merit and contribution to the economy. Energy financing presents a vital opportunity for Islamic banks to show their importance and contribution through financing energy infrastructure. We argue in this paper that Islamic banks will themselves benefit from increased financing to energy sector since it will help them i) narrow their banking spreads, ii) increase financing to deposit ratio and iii) reduce operational inefficiencies. Economy wide effects of resolution of energy crisis will help in increasing investment, productivity, fiscal space and export competitiveness. It will also help in reducing crowding out of private sector credit, capital flight and deindustrialization.

Keywords Islamic banking, Islamic finance, Energy financing, Alternate energy

JEL Codes Q42, Q43, Q48

29 Author: Salman Ahmed Shaikh is a Research Associate at IBA and he teaches Economics courses at

undergraduate and graduate level. He can be contacted at: [email protected]


1. Introduction Growth literature highlights the importance of capital formation, complimentary

investments and physical and social infrastructure. The long term growth literature from Harrod (1939)-Domer (1946), Solow (1956) and to Romer (1986) is almost unanimous on the role of savings and capital accumulation for long term economic growth. Endogenous growth theory sheds light on importance of complimentary investments and public infrastructure that can not only result in increasing returns to scale, but also lead to permanent source of continued long term growth.

Even though the role of energy infrastructure cannot be overemphasized for an industrializing country, Pakistan has not been able to attain energy sufficiency as yet. Table 1 shows the supply and demand position currently and projections for the future.

Table 1: Supply and Demand Position: 2014-2020 (MW) Supply and Demand Position: 2014-2020 (MW) 2014 2015 2016 2017 2018 2019 2020 Existing Generation 15,903 15,903 15,903 15,903 15,903 15,903 15,903 Proposal/Committed Generation

13,520 14,607 16,134 18,448 18,448 18,448 18,448

Existing + Committed Generation

29,423 30,510 32,037 34,351 34,351 34,351 34,351

Expected Available Generation

23,538 24,408 25,630 27,481 27,481 27,481 27,481

Demand (Summer Peak) 25,919 28,029 30,223 35,504 34,918 37,907 41,132 Surplus/Deficit Generation -2,381 -3,621 -4,593 -8,023 -7,437 -10,426 -13,651

Source: Private Power & Infrastructure Board

This situation requires diversifying energy mix to better meet demand. Table 2 gives account of installed capacity for electricity generation in Pakistan. It points to the fact that with increased pressure on thermal and hydel with gas and water shortage imminent in future, the country needs to move towards non-depletable sources of energy.

Table 2: Composition of Installed Capacity (MW)

Pepco System KESC System Total Hydel (WAPDA) 6,444 - 6,444 Hydel (IPPs)** 111 - 111 Thermal (GENCOs/KESC) 4,885 1,821 6,706 Thermal (IPPs) 8,325 262 8,587 Rentals 403 50 453 Nuclear (CHASNUPP & KANUPP)

650 137 787

Others 324 324 Total 20,818 2,594 23,412

Source: Private Power & Infrastructure Board


What is also clear from Table 2 is that capacity utilization is very low. Circular debt has created frictions in efficient utilization of capacity. Despite having sufficient capacity, the country has not been able to produce the electricity and other energy goods in required quantities. Hence, prices have increased which has resulted in the rise of cost of production and due to this major industries have lost competitive edge amidst increased global competition in a free trade era.

To meet the increased energy demand, solar and wind energy could be explored as alternate sources of energy. Pakistan is a tropical country and has a large coastal area. Furthermore, corporatization of Thar coal project can expedite increased use of coal in the energy mix.

In this paper, we discuss the role Islamic banks can play in providing energy financing. We discuss that Islamic banking has the potential to do so and how energy financing can also help Islamic banks in improving their liquidity management, asset utilization and efficiency ratios.

The paper proceeds as follows. In section 2, we give an overview of growth in Islamic banking in Pakistan in the period 2002-12. In section 3, we discuss why energy financing is needed and how it can resolve the energy crisis in Pakistan. We also discuss the effects of energy crisis on inflation, imports, investments and growth. In section 4, we discuss how Islamic banks can contribute in energy financing. Here, we discuss the three important generic Islamic finance contracts – namely Ijarah, Istisna and Diminishing Musharakah – that can be used to provide energy financing. We discuss various financing structures including i) standalone financing, ii) syndicate financing and iii) public issuance of standardized securities etc. Finally, in section 5, we discuss how Islamic banks will also benefit from energy financing, both qualitatively and quantitatively.

2. Overview of Islamic Banking in Pakistan During the last decade and half, the Islamic financial industry has seen tremendous

growth even when the conventional financial institutions went into a deep crisis. The Islamic finance industry, rapidly growing over the last 40 years, has demonstrated its potential with robust, steady 15-20 percent growth throughout the recent economic crisis.

Some economists argue that this growth is owed to some unique features inherent in Islamic financial products. Adel (2010) explained the economic merits of Islamic banking by pointing out that credit expansion through Islamic banking is linked to the growth of the real economy by allowing credit primarily for the purchase of real goods and services. It also requires the creditor to bear the risk of default by prohibiting the sale of debt, thereby ensuring that he evaluates the risk more carefully.

Chapra (2007) highlighting the benefits of asset backed financing by Islamic banks stated that asset-based debt should further help by not allowing the debt to exceed the growth of the real economy. The introduction of such a discipline carries the potential of helping realize not only greater stability, but also greater efficiency and equity in the financial system.

In Pakistan, the second phase of Islamic banking started in 2002. The first phase during the 1980s under the patronage of Zia-ul-Haq was not successful. However, with increased participation of Shari’ah scholars in the policy making, product design, audit and supervision, the second phase has seen impressive and consistent growth. Now,


Islamic banking in Pakistan is an established industry with 9% market share achieved in just over a decade. There are 5 full- fledged Islamic banks and 18 other commercial banks that operate Islamic banking windows alongside conventional banking in Pakistan.

Figure 1 shows the growth in assets, deposits and advances in Islamic banking industry in Pakistan. The exponential and uninterrupted growth is evident from this graph.

Figure 1: Growth in Islamic Banking Assets, Deposits & Advances

Source: Islamic Banking Bulletin, SBP, Various Issues

Figure 2 shows the profitability in Islamic banking during the last 6 years in Pakistan as measured by the accounting ratio, Return on Equity (ROE). It can be seen that initially some banks took time to consolidate and break even. But in later periods, they have registered strong growth with ROE reaching even 18% and sustaining it to be in double digits despite the security and energy crisis in the country.

Figure 2: Profitability Growth in Islamic Banking



3. Need for Energy Financing Brunnschweiler (2009) in an empirical study of 119 non-OECD countries using

panel data concluded that lack of financing is one of the major obstacles for minimal use of renewable energy in developing countries. Financial sectors of these countries are often underdeveloped and are unable to efficiently channel loans to produce renewable energy.

For estimating the cost of energy on output in Pakistan, Siddiqui et al (2011) estimated the cost of un-served energy using primary data from firms. According to their estimates, the overall industrial sector loss ranges between Rs 269 and Rs 819 billion. The figure roughly equals 1% to 3% of total GDP.

Recently, in fertilizer sector alone, Engro’s Enven plant received gas for only 45 days in 2012, Pakarab Fertilizers for 100 days, Dawood Hercules for 70 days and Agritech for 100 days.

In Figure 3, we show that the energy shortfall has also contributed in low manufacturing exports to the total exports ratio of the country. Exports of primary goods increased from 11% in FY07 to 18% in FY11 while exports of manufactured goods decreased from 77% in FY07 to 69% in FY11.

Figure 3: Export Composition by Category (%)

Source: Pakistan Bureau of Statistics

Furthermore, oil related imports of Pakistan now exceed one third of total imports. Rising oil prices have resulted in higher imports, balance of payments deficit, decrease in value of rupee and soaring inflation.

It is now appreciated by almost all circles that at current consumer prices for electricity, the energy mix has to be modified. This modification in mix requires new projects and these projects require huge amount of financing. Government is already cash starved with mounting fiscal deficit and it cannot sustain the subsidies to let the current energy mix lead the country to meet future challenges on demand side. It is also hard for government to raise sufficient funds in the short run to undertake new projects to achieve modification in energy mix.

Figure 4 shows the energy inflation in the past 8 years for Pakistan.


Figure 4: Energy Inflation Rate (%)

Source: Economic Survey 2012-13 Statistical Appendix

Since energy is a major component of cost of production and transportation, it leads to cost-push inflation spiral in the overall economy.

To meet the growing energy deficit, the investment in energy infrastructure has been very low as well. Figure 5 shows the gross fixed capital formation in electricity generation and distribution.

Figure 5: Gross Fixed Capital Formation (GFCF) in Electricity (in mln PKR)

Source: Economic Survey 2012-13 Statistical Appendix

It can be seen that this trend in electricity generation and distribution investment is not sufficient to meet the energy challenges of present and future. With increased monetization of debt and soaring interest rates, investment in general has dried up and last 2 years have seen no increase and even a slight decline in investment in electricity generation and distribution.

Energy crisis along with security crisis has now led to a situation where Pakistan’s investment to GDP ratio is the lowest in the region.


Figure 6: Investment to GDP Ratio (%)

Source: CIA Fact Book

4. How Islamic Banks Can Contribute in Energy Financing As we saw in Figure 1, the gap between deposits and advances has widened in

Islamic banking. Since 2006, Islamic banking deposits have grown by 10% whereas; the advances have grown by only 7%. Islamic banks have surplus liquidity and if they can provide this in the form of energy financing, it will improve their profitability and efficiency ratios. It can also enable Islamic banks to cut down their spreads which are currently higher than conventional banks. This in turn will make them more competitive with other banks.

Furthermore, as can be seen from Figure 7, the contribution of energy financing in the total financing mix is hovering around 7% to 8%. Hence, with stagnant industrial demand for credit, Islamic banks can increase their financing to the energy sector.

Figure 7: Contribution of Energy Financing (%)



In this section, we discuss the product type alternatives that can be used for energy financing. Next, we also discuss the 3 intermediation structures through which energy financing can be provided through Islamic banking.

4.1 Mathematical Exposition of Islamic Banking Model The basic structure of Islamic banking can be explained mathematically as follows.

First, an Islamic bank creates an asset pool (AP) which consists of bank’s equity (E) and deposits (D). Deposits include two further classifications, i.e. remunerative deposit (RD) and non-remunerative deposit (NRD). RDs are mobilized using partnership mode ‘Mudarabah’ with bank’s shareholders and depositors as partners. Profit sharing ratio is agreed at the start of this partnership. NRDs are mobilized using Qard (non-compensatory loan).

Mathematically, we have: AP = E + RD + NRD ..... (i)

This pool of assets is used to provide asset backed financing (ABF). In an Islamic banking model:

AP = ABF ..... (ii)

ABF consists of various financing assets based on different underlying financing contracts, i.e. Ijarah, Diminishing Musharakah, Murabaha, Istisna etc. Islamic bank does not lend money. It provides asset backed financing in which the asset is owned by the bank. These financing modes can be categorized as lease based financing (LBF) or credit sale based financing (CSBF).

Hence, (ii) can also be written as: AP = ABF = LBF + CSBF ..... (iii)

Income stream is generated either through profit on credit sale or rent for use of asset.

Hence, income (I) comes in the form of rent (R) or profit on sale (P).

I = R + P ..... (iv)

If R is some proportion of LBF and P is some proportion of CSBF, then (iv) can also be written as:

I = LBF + CSBF ..... (v)

Since Islamic banks use the same interbank benchmark rate (KIBOR) for pricing assets in credit sale for profit determination and computing rentals necessary to amortize the cost of asset during lease period, and can be assumed to be same except for term premia and counterparty risk premia in customized financing assets.

I = (LBF + CSBF) ..... (vi)

Where

Replacing AP for (LBF + CSBF) in (vi), we can see that income is distributed among the contributors in pool, including bank’s shareholders and depositors. To achieve spreads for financial intermediation function, profit sharing is done between bank and depositors as per the pre-agreed profit sharing ratio.


I = PSRRD IRD + PSRB IB ..... (vi)

Where, I = IRD + IB. IRD represents income share of depositors and IB represents income share of the bank.

4.2 Modes of Financing For a bank, assets among other things include the financing and advances made by

the bank for profit. Some of the important and often used financing products of Islamic banks are discussed below.

4.2.1 Diminishing Musharakah Diminishing Musharakah is one of the major modes of financing used in Islamic

banking. It is usually used to finance fixed assets for long term consumer and corporate financing.

In Diminishing Musharakah, the customer approaches the bank for joint purchase of an asset/property. Designated valuation agencies are consulted for the valuation of the asset/property. The seller of the property is paid by the bank and the bank and the customer enter into a Musharakah Agreement.

It is referred to as ‘Diminishing Musharakah’ because of the arrangement by which the ownership stake of the tenant increases and that of the bank decreases with the passage of time. The rent decreases as the ownership stake of the tenant increases.

The share of the bank in asset/property is divided into units. These units are purchased by the customer periodically. When he has purchased all units, he becomes the sole owner of the asset/property.

A numerical example will further explain this product structure. Table 3 presents the details. The formulas used to compute the results are listed below:

Number of units = Tenure of lease in years x number of months in year Unit price (Rs.) = Financing amount of asset required (Rs) / no. of units Rent per unit per Month = (Rental rate/12) x unit price Total rent per month (Rs) = Rent per unit per month (Rs) x no. of outstanding units

Total Starting Rent (Rs) = Total Rent per Month (Rs) + Unit Price

Table 3: Rental Computations in Islamic Mortgage

Expected Rentals - Assets Financing Amount of Asset Required (Rs) 1,000,000

Rental Rate (%) 15

Tenure of Lease (Years) 20

No. of Units 240

Unit Price (Rs) 4,167

Rent Per Unit Per Month (Rs) 52

Total Starting Rent (Rs) 16,667


Table 4 presents extract of a payment schedule. It can be seen that monthly payments are declining with decrease in rents. It is because the units in ownership of bank decrease with each additional unit purchased by the client every month. Monthly interest payment in a conventional amortization schedule is replaced by monthly rent. Plus, the principal repayment in a conventional amortization schedule is replaced by unit price.

Table 4: Payment Schedule in Islamic Mortgage

Month Monthly Rent Per Unit Price Monthly

Payment Balance

Units Balance Unit Value

0 60 2,000,000 1 25,812.5 33,333.33 59,145.83 59 1,966,666.47 2 25,375 33,333.33 58,708.33 58 1,933,333.14 3 24,937.5 33,333.33 58,270.83 57 1,899,999.81 4 24,500 33,333.33 57,833.33 56 1,866,666.48 5 24,062.5 33,333.33 57,395.83 55 1,833,333.15 .. .. .. .. .. ..

56 1,750 33,333.33 35,083.33 4 133,333.32 57 1,312.5 33,333.33 34,645.83 3 99,999.99 58 875 33,333.33 34,208.33 2 66,666.66 59 437.5 33,333.33 33,770.83 1 33,333.33 60 0 33,333.33 33,333.33 0 -

4.2.2 Ijarah In Ijarah, the right to use an asset is obtained and rent is paid for the use of asset.

The process flow is as follows:

The customer approaches the bank for obtaining an asset on lease. The customer undertakes to make periodic lease payments over the lease period. Lease agreement and agency agreement is signed. The customer buys the asset as an agent to the bank. Bank pays the vendor and receives the title of the asset. The bank hands over the asset to the customer on lease and the customer starts using the asset and pays rent for each period. At maturity of lease, the customer can purchase the asset from the bank by way of a separate purchase agreement.

The lease period starts when the asset has been delivered by the lessee in a usable condition. The bank (Lessor) bears the ownership related costs and the customer (Lessee) bears the usage related costs. If the asset is destroyed or becomes unusable, the bank stops taking rent and does not charge rent for that period.

For computing rentals which amortizes the investment in asset for the bank, typical annuity formula is used:

Where ‘i’ is the target return, ‘n’ is the duration of lease, ‘PVA’ is required lease

financing amount and ‘A’ is periodic value of rentals.


4.2.3. Istisna It is used in financing goods that are not yet ready for sale and will have to be

manufactured. Examples include architect services, engineering services etc. It is an order to a producer to manufacture a specific commodity for the purchaser. It is used in pre-shipment exports financing and usable in all other situations where goods have to be manufactured before sale. In energy financing, this structure can be used in project financing where a tender for construction project is awarded to a contractor.

Figure 8: Share of DM, Ijarah and Istisna in Total Advances (%)


4.3. Economic Merits of Islamic Modes of Financing Often, in commercial financing, huge financing is required for different projects

that take time to be completed; for instance, construction of plant, highway, dams etc. The firms providing services to undertake and execute such projects may have expertise, but lack funds to undertake such projects. Financial intermediation can bring necessary financing, liquidity and risk mitigation that enables the unknown counterparties to undertake such projects.

Giving funds for raw material purchase directly by the client will pose certain challenges of agency conflict and moral hazard. In such a case, the financial intermediary can aid with better credibility, standing, and economies of scale in authenticating the counterparties and the ability to effectively and efficiently enforce contracts.

There is often need of making payments for resource supplies before production is complete. To keep the production cycle going, Istisna can be used to ensure resource supplies availability and production.

Often, it is desirable to keep low levels of inventory and improve turnover ratios. Keeping huge inventory all the time will require inventory maintenance cost and may result in underemployment of assets at times. It will dampen liquidity and turnover ratios


and hence affect stock price of companies. Using Istisna when financing is needed for new project will reduce operational and financial inefficiencies.

Often, construction and engineering companies enter into big-volume, but customized contracts with institutional clients. Keeping inventory beforehand is neither financially possible nor operationally appropriate. Hence, financing the project requirements after project deal is signed will enable firms to work with less cash tied up.

From the risk and profitability perspective, Islamic modes of financing keep the Islamic financial system liquid and less prone to risk due to asset backing. Islamic financial intermediary enables credit availability to ensure that productive transactions are executed and also, it reduces the transaction and monitoring costs which result in more productive transactions happening in the economy.

Often, the investors with bank (the deposit holders) are risk averse and want consistent returns. But, small savers do not have enough funds to finance big volume projects directly. But, using investors’ pool of funds to provide financing, the investors are able to share in benefit of such economic activities.

Financing big projects without financial intermediation will be a very difficult task. Equity financing is also costly in some ways because of high floatation cost, risk of under subscription and inflexibility in modifying capital structure when needed. But, using investors’ pool of funds to provide financing, the banks can effectively finance such big projects that have positive benefits to direct parties involved as well as positive externalities enjoyed by masses in the society.

4.4. Financing structures In financing structures, there are three possibilities, i) standalone bank financing, ii)

syndicate financing, iii) public issuance of securities.

4.4.1. Standalone Financing Currently, the size of Islamic banks is not as big as conventional banks in terms of

assets and capital base. Due to prudential regulations, they cannot usually finance big projects on standalone basis. But, if a project’s capital requirement is divisible in separate chunks of capital goods, then, standalone financing can be obtained. It is also going to be most useful when only partial financing is required for some energy infrastructure.

4.4.2 Syndicate Financing In syndicate financing, group of banks join to provide financing for a big project. It

has many advantages over standalone financing. First, it increases the number of potential projects that can be financed through Islamic banking. Second, it diversifies the risk of the banks. Third, it enables more effective pooling of resources. Fourth, it still is cheap and customizable since small numbers of financiers are involved and this method also avoids the floatation cost and underwriting uncertainties.

4.4.3. Public Issuance of Securities Sovereign and corporate Sukuk issuance can also help in obtaining long term

finance for big projects. Issuance of these securities can also result in deepening of financial markets with more investment avenues. This will promote savings culture and make financial markets more competitive and responsive to the small savers. Currently, banking spreads in Pakistan are at an all time high.


In Pakistan, Government of Pakistan (GoP) had already issued several Ijarah Sukuk and its public sector units like National Highway Authority and WAPDA has also issued Sukuk in past. As much as 2% of sovereign financing is now by way of Sukuk in Pakistan. These Sukuk can deepen Islamic money market and provide more investment alternatives to Islamic banks’ treasuries.

Further economic benefits of the proposal to the investors are:

i. Investors will be able to pocket better returns on investments than the returns they get from investing in Islamic commercial banks.

ii. Investors will be able to bypass unnecessary intermediation and will save transaction costs and be able to have direct access to the more profitable investment opportunity.

iii. Sukuk issuance will increase investment opportunities available to the investors and will allow them to increase return on their investments.

Apparently, this mechanism may seem a challenge to the banking industry and other financial intermediaries, but looking from another perspective, this will actually help in achieving a sound and efficient financial framework which is completely in sync with real sector of the economy. The proposal will benefit financial industry in many ways, some of which are:

i. It will help decrease the swelling banking spreads and will make the Islamic financial institutions become more competitive.

ii. With upward pressure on profit rates, savings will be encouraged and gap between savings and investment will contract with the passage of time.

iii. It will entice banks to provide finance to corporate private sector rather than using depositor’s money in liquid statutory investments including organized Commodity Murabaha which crowds out the private sector.

Furthermore, it will make the whole conduct of monetary policy more effective as well as efficient. Following benefits will accrue from the proposal in this spectrum:

i. Tight monetary policy increases the cost of financing and hence helps in containing monetary growth. But, the same effect does not appear in deposit rates of banks’ products. Hence, if inflation persists, people prefer spending than earning negative real returns with low deposit rates.

ii. With the launch of this proposal, the policy rate will have its immediate bearing not only on banks’ financing rates, but also on banks’ deposit rates. Hence, the objective of containing monetary growth and aggregate demand will be achieved from two ends i.e. financing will become costlier as well as people with surplus funds will be offered higher deposit rates by banks.

iii. It will also compel banks to finance more prudently as their spreads will be cut down and they will not be able to finance imprudently. Hence, this may help in containing NPLs resulting from lax credit policies, lax risk management or from both.

iv. If the country’s nominal GDP is increasing, then, the benefits will be accrued to the investors, hence, the benefits of growth will trickle down much more directly.


5. How will Energy Financing Help Islamic Banks 5.1. Reduce Spreads

Islamic banking spreads - the difference between average financing and deposit rates - have been constantly higher than the overall banking spreads in Pakistan during the last three years as shown in Table 3.

Table 3: Comparison of Banking Spreads

Period IB Spreads Banking Spreads Sep-11 8.40% 6.70% Jun-11 8.80% 6.90% Mar-11 8.40% 6.90% Dec-10 7.10% 6.80% Sep-10 7.70% 6.80% Jun-10 7.70% 6.90% Mar-10 7.70% 6.60% Dec-09 7.00% 6.60%


By utilizing the growing deposit base in long term energy financing, the Islamic banks will be able to improve profitability ratios and will not have to depress deposit rates which they were doing before as they did not make effective use of pool of assets available for financing.

5.2. Improve Financing to Deposit Ratio Figure 9 reports declining advance to deposit ratio in Islamic banking over the

period 2006-12. Islamic banks in Pakistan have surplus liquidity, but rather than using the more preferable modes of financing with a lot of cushion in the form of liquidity, Islamic banks give their liquid funds to conventional banks. This is done by using financial innovativeness to bypass legal hitches and in a way, they are sometimes serving to strengthen interest based conventional banking.

Figure 9: Advance to Deposit Ratio in Islamic Banking

0.000.100.200.300.400.500.600.700.800.90

ADR

ADR



Energy financing will enable them to use their liquidity themselves and earn greater profits on new financing assets creation rather than placing the funds with conventional banks.

5.3. Improve Image Less than 1% of Islamic financing assets are involved in micro financing.

Financing costs are also high in Islamic banking as depicted by the high spreads ratio. Contribution to SME financing and rural presence is also low in Islamic banking as compared to conventional banking in Pakistan. This has raised the issue of form and substance in Islamic banking. Energy financing is one specific avenue for Islamic banks to explore and through which they can meaningfully create a positive and visible contribution in the economy.

5.4. Deepening of Islamic Money Market Through issuance of more Sukuk, the investment class assets universe will expand

and it will enable the Islamic-conscious individual and institutional investors to effectively diversify their portfolios. Treasuries of Islamic banks will also have an expanded set of investment avenues. It will increase liquidity of these Sukuk and generate wider interest among all investors in the economy to consider investing in these investment vehicles.

Conclusion In this paper, we analyzed the role Islamic banks can play through energy financing

to help contribute in resolution of energy crisis. Our data analysis showed that Islamic banks have grown and penetrated swiftly in Pakistan’s banking sector. However, questions are still raised about Islamic banks’ differential economic merit and contribution to the economy. We argued that energy financing presents a vital opportunity for Islamic banks to answer this criticism. We analyzed how this endeavor will help Islamic banks to improve their financing to deposit ratio and narrow the gap between high rate of deposits growth and low rate of advances growth. Energy financing will help in achieving operational efficiency and that may enable Islamic banks to reduce their banking spreads and appear as much competitive as the big conventional banks.

References Brunnschweiler, Christa N. (2009), “Finance for Renewable Energy: An Empirical

Analysis of Developing and Transition Economies”, Center of Economic Research at ETH Zurich, Working Paper 09/117.

Domar, Evsey (1946). Capital Expansion, Rate of Growth, and Employment. Econometrica, 14 (2), pp. 137–47.

Harrod, Roy F. (1939). An Essay in Dynamic Theory. The Economic Journal, 49 (193), pp. 14–33.

Siddiqui, R., Jalil, H. H., Nasir, M., Malik, W. S., & Khalid, M. (2011), ‘The Cost of Unserved Energy: Evidence from Selected Industrial Cities of Pakistan’, PIDE Working Paper No 75.

Romer, Paul M., (1986). Increasing Returns and Long-Run Growth, Journal of Political Economy, 94 (5), pp. 1002-37.

Solow, Robert M. (1956). A Contribution to the Theory of Economic Growth, Quarterly Journal of Economics, 70 (1), pp. 65–94.

State Bank of Pakistan [2006-12], Islamic Banking Bulletin, Various Issues.


Consumer Perceptions of Islamic Banks: The Case of Saudi Arabia

By Imran khokhar*

Bukhari M. S. Sillah

Abstract: There is no clear line and distinction between Islamic and conventional banks in Saudi Arabia. Banks which are perceived as non-Islamic banks do offer various types of Islamic banking products beside their conventional products. Some of the banks are full-fledged Islamic banks. However, the Saudi Arabian banks do not carry the word “Islamic” in their names, as it pertains in U.A.E, Malaysia, Pakistan etc. So, it is hypothesized that the general public might not attach significance to the distinction between Islamic and conventional banks. This paper is conducted to assess the perceptions of Saudi Arabian people of Islamic banking in Saudi Arabia, and to draw conclusions from their views about the degree of the Shariah compliance of the Islamic banking practice. The results of this paper imply that the customers are generally satisfied with the Islamic banking practice, but they want them to do more than current level because they perceive that their banking operations are just marginally Shariah compliant. The customers also generally disapprove of the window Islamic banking by the conventional banks.

Key Words: Islamic banking, Perceptions, Shariah Compliance, Customers, Conventional banks

Introduction Islamic Banking is the banking system that operates under the law of Sharia

(Islamic jurisprudence). According to Sharia, any type of usury, interest or getting fixed

* Authors: Imran khokhar and Bukhari M. S. Sillah, Department of Economics, College

of Business Administration, King Saud University, Riyadh, Saudi Arabia. [email protected], [email protected], and bsillah@ ksu.edu.sa, [email protected]


money on loans is Haram (forbidden). In addition, Sharia prohibits investing in businesses that are considered Haram in Islam (i.e. selling or making of alcohol, pornography etc...). Islamic banks perform the same essential functions as other banks do in the conventional system, except that they should carry out their transactions in accordance with the rules and principles of Islam (Henry and Wilson, 2004; Iqbal and Mirakhor, 2007). Islamic banking has been launched during 1970’s when the world first full-fledged Islamic commercial bank (Dubai Islamic Bank) started operation in Dubai, U.A.E in 1975. Since then the Islamic banking industry started growing rapidly not only in the Muslim countries but also in some non-Muslim countries. Islamic banks have more than three hundreds institutions over 51 countries, and its assets reached about $400 billion in 2009. According to World Islamic Banking Competitiveness Report 2013–14 Islamic banking assets with commercial banks globally are set to cross $ 1.7t in 2013 suggesting an annual growth of 17.6% over last four years. It is predicted that Islamic banks will control around 40-50 per cent of Muslims’ savings by 2009/10, (Zaher and Hassan, 2001). The popularity of the Islamic banking system is not limited to the Islamic banks only. Large international conventional banks are showing increasing interest in the Islamic banking system as well, (Kamal Naser et al., 1999).The conventional banks, such as HSBC and Citibank, have established Islamic banking branches in some countries to meet their Muslim customers’ needs. This is evidently clear in Saudi Arabia, where the distinction between conventional and Islamic banks in terms of offering Islamic financial services is increasingly blurred. Saudi Arabia has a profitable and stable banking industry. Its banking industry is regulated by the Saudi Arabian Monetary Agency (SAMA). It has the largest assets of both Islamic and conventional banks among Gulf Cooperation Council Countries (GCCs), (Alkassim2005). According to SAMA’s 49th annual report; the number of commercial banks operating in the Kingdom of Saudi Arabia stood at 23 at the end of 2012, including branches of some foreign banks. Saudi Arabia is the largest market for Islamic finance in terms of size. The largest Islamic bank in the world, Al-Rajhi Banking and Investment Corporation, is based in Saudi Arabia. The bank had 267,383(SAR million) in assets at the end of 2012. The country hosts the Islamic Development Bank, which is an equivalent of Muslim countries’ World Bank. Saudi Islamic banks have a clear competitive advantage over their conventional competitors. The deposit growth of Islamic banks have been higher than that of the Saudi banking sector as seen by the CAGR (Compound Annual Growth Rate) growth of 17.4% in the period 2002-05 as compared to 12.9% recorded by the Saudi banking sector for the same period. Islamic banking industry is growing rapidly in Saudi Arabia forcing some conventional banks to convert wholly to Islamic banking practices, such as the case of Bank Al-Ahli. This phenomenon has encouraged the authors to investigate the performance of this industry through the perceptions of its customers. Since there is no banking regulation in the country forbidding the banks to offer conventional products, the paper attempts to explore whether or not the perceptions and attitudes of the customers have any role in forcing the banks to Islamize. We conduct a questionnaire survey to collect the required data from the customers to examine the hypotheses of the paper. Specifically the paper examines the factors that inspire customers to choose Islamic banking services. This includes determining the level of knowledge of the customers about the Islamic banking practice and their perceptions on the reliability of its products and service quality. The rest of this paper is organized as follows: section 2 summarizes and discusses some relevant literature, section 3 discusses the method, hypotheses and results, and section 4 presents the conclusions and implications.


Some relevant literature In reviewing some relevant literature, we have identified five areas of interest that

some previous papers have investigated with respect to the customer-bank relations of the Islamic banks. They are customer satisfaction about the Islamic bank operations in general and factors that enhance the customer satisfaction, customer awareness, bank selection criteria, perception about the degree of Islamization of Islamic bank products, and customer perception about the Islamic banks. Badara et al (2013) find the customer satisfaction among prospective customers depend on the bank staff responsiveness and the bank assurance. The higher the staff responsiveness is the higher the customer satisfaction. Another area of interest is the bank selection and the reason for selecting or doing business with an Islamic bank. A good number of papers have found that religion has been a key factor for most customers for selecting or doing business with Islamic banks. This could be a biased result given the fact that most of these studies were conducted in Muslim-dominated countries, and hence the samples were skewed in favor of Muslim respondents. These respondents might not have a choice from a religious perspective but to do business with Islamic banks. Subhani et al (2012) conducted their study in Malaysia and Bley and Kuehn (2004) conducted their study in United Arab Emirates and these studies find the respondents to select Islamic banks on the basis of religious principle. Non-Muslim respondents select Islamic banks on the basis of lower transaction costs, Hadayat and Al-Buwardi (2012), Saini et al (2011). Other Non-Muslim respondents choose Islamic banks on the basis of high profit and high earnings paid on the deposits, Haque (2010) and Gerrard and Cunningham (1997). Another area of interest the literature has examined is the level of awareness and knowledge of the customers about the various Islamic finance modes. In Pakistan, Khan and Asghar (2012) find that customers in general are aware of Islamic banking models, but when Karim (2012) examines awareness of customers of one bank out of the bank population in Pakistan, the customers were found not fully aware of what financing products their bank offered. In Malaysia, Thambiah et al (2011) find that urban customers have higher level of awareness than the rural customers about the Islamic bank financing modes. In Bosnia and Herzegovina, the customers have little knowledge and awareness, Ergun and Djedovic (2011) and similar findings were arrived at in Australia by Rammal and Zurbruegg(2007). In Bangladesh, customers are aware of the deposit mobilization instruments, but they have little knowledge of the financing instruments. In United Arab Emirates and Jordan, the customers are generally aware of the financing modes, Bley and Kuehn (2004) and Naser et al (1999) respectively. Interestingly Naser et al (1999) finds that customers know Mudarabah and Musharakah modes but do not use them, and they are found to hold both Islamic bank accounts and interest-based accounts. This situation could change by now, as the study was conducted fourteen years ago with growing Islamic banking practices in the Middle East in recent years, customers’ awareness might have changed. This is reflected in the summary table below; as the literature gets older the level of awareness and knowledge of Islamic banking modes is low. In the 1990’s, both Muslims and Non-Muslims, were generally unaware of Islamic banking practices. The other area of interest the literature has treated is the general perception and attitude of the customers about the Islamic bank and their performance. Khan and Asghar (2012) find that in Pakistan customers generally hold positive attitude about the Islamic banks, and they are always found ready to do business with the Islamic banks. In contrast, Akbar et al (2012) find the Muslims in UK do not fully approve of the Islamic banks, because they find them to be not fully aligned with the Islamic teaching. In Qatar, the customers’ perceptions are highly influenced by the premises and tangible assets of the banks and not by the competence areas, Hossain and Leo (2009). This will give the bank observers


distorted picture and view about the banks. Thus, the Islamic bank observers should not take the positive perception of customers on the face value. They should endeavor to know the factors that influence the perception. Similarly, the bank observers should know whether or not positive customer perceptions translate into actions. For example do customers who hold positive attitude about the Islamic banks increasingly do business with the Islamic banks?

Our study attempts to further enrich the literature by not only revisiting the aforementioned five interest areas, but also constructing and testing a set of hypotheses about the customer-bank relations of the Islamic banks. These hypotheses are stated and explained in the section of research methods.

Methods, Results and Analysis Methods & Hypotheses

The paper attempts to explore the customer bank relations of the Islamic banks. We constructed a questionnaire consists of five categories namely demography, religious commitment, product quality, customer satisfaction and customer suggestion. Each category has a set of hypotheses or issues to investigate, as explained below:

A. Demography Under this category the paper profiles the bank customers in accordance to their

sex, nationality, education level, age, employment, social status and incomes. This profiling is expected to produce for us a typical/average bank customer in the sample and the level of the relation of this average customer with the Islamic bank.

B. Religious Commitment and knowledge This section investigates the degree of religious devotion and dedication of the

customers, and whether or not the level of religious devotion is predictor of selecting an Islamic bank. The customer’s knowledge of Islamic banking practices is assessed and their knowledge is employed in the analysis to ascertain their approval and disapproval of Islamic banking services. The hypotheses to test are:

1. Islamic banking practice and religious commitment HO: Customers’ religious commitment is not associated with Islamic banking

practice

HA: Customers’ religious commitment is associated with Islamic banking practice

The respondents are allowed to choose their religious commitment on the labels of highly committed, moderately committed and not committed.

2. Islamic banking practice and Knowledge of Islam HO: Customers, who are knowledgeable of Islam, are not associated with Islamic

banking practice

HA: Customers, who are knowledgeable of Islam, are associated with Islamic banking practice.

The respondents are allowed to choose their level of knowledge of Islam on the scale of excellent knowledge, moderate knowledge, and poor knowledge. The


Islamic banking practice concerns the degree of Islamization of the Islamic banking operations. The respondents are asked to answer YES, if they believe that the banking operation conforms to the Shariah teachings, and NO, otherwise. The respondents are also asked to answer YES, if they believe that the Islamic banks are different from the conventional banks and NO, otherwise.

3. Approval of Islamic banking services and knowledge of Islamic banking HO: Customers, who are knowledgeable of Islamic banking, are not associated

with Islamic banking products

HA: Customers, who are knowledgeable of Islamic banking, are associated with Islamic banking products

The respondents are allowed to choose their level of knowledge of Islamic banking on the scale of excellent knowledge, moderate knowledge, and poor knowledge.

C. Products Quality This section explores the customers’ perceptions about the quality of the Islamic

bank products in terms of conformity with Sharia, meeting the customer needs and the awareness level of the customers about the various Islamic financing models. The section solicits the perception of the customers on the degree of Islamization of the Islamic banking services. The hypothesis to test is:

4. Hypothesis: customer awareness and the Islamic banking practice HO: Customers who are aware and use the Islamic banking products are not

associated with the degree of Islamization of the Islamic banking services

HA: Customers who are aware and use the Islamic banking products are associated with the degree of Islamization of the Islamic banking services

The respondents are asked to rate their own awareness about the Islamic banking products on the scale of “aware of, aware of it and used it, and not aware of it”, and then they are given a number of Islamic banking products to rate on the degree of their Shariah compliance on the scale of highly Shariah compliant, controversially Shariah compliant, and not Shariah compliant.

D. Customer satisfaction This section gauges the level of satisfaction of the Islamic bank customers in respect to 23 different banking customer care services. The customers are asked to rate their satisfaction on a scale of 1 to 7. Where 1 denotes highly unsatisfied and 7 denotes highly satisfied.

E. Customer suggestion This section presents three open ended questions for the customers. The first question wants customers to suggest things that the Islamic banks should do, given that they currently do not do those things. The second question asks the customers to suggest things that the banks stop doing, given that they currently do those things. Finally, the customers are asked to suggest further rooms for improving the practices of Islamic banks in Saudi Arabia.


Results and Analysis One hundred and seven questionnaire forms were distributed randomly, and 90% of

the respondents have responded to all the questions in the survey. The respondents are 56% male and 44% female; they are mostly Saudis, accounting for 94% of the respondents. Married respondents constitute 53% and the single respondents account for 44%. 72% of respondents are aged between 20 to 40 years; 58% of them are government employees, and 22% of them students. 36% of them have a high school certificate and 56% has an undergraduate degree. They generally come from four major income groups. One group earn less than SR 3000 a month and it constitutes 31% of the respondents. This group could come mostly from the student population. Another group earns between SR 5000 and SR 10000 and it accounts for 25% of the sample. The fourth group earns between SR 10000 and SR 20000 a month.

In terms of Knowledge of Islam, most respondents describe themselves as moderate devout Muslims accounting for 69% of the respondents, and those who describe themselves as highly devout constitute 25%. Those, who claim to have good understanding of Islam accounts for 75%, and those who claim to have excellent understanding of Islam account for 21%. 57% of the respondents say they have good knowledge of Islamic banking. 15% has an excellent knowledge and 14% has poor knowledge. Most of them know that interest is forbidden in Islam and they perceive Islamic banks to be different from the conventional banks; they do banking with the Islamic banks, and they believe that the Islamic banks are alternative to the conventional banks. But their selection of Islamic banks is influenced by religion, they use Islamic banks mainly for salary account services, and only 40% of them think that the Islamic banks in Saudi Arabia are not truly Islamic. They do not know how competent the Shariah board members are, and 62% of them do not approve or do not know the Shariah competence of the window Islamic banking by conventional banks.

70% of the respondents do not know or have limited knowledge about the Shariah competence of the Islamic banking products. The contract theories of Islamic banking, finance and investment, of which the respondents are widely aware of, are MUDARBAH, MURABHAH, WAKALA, TUWARRUQ, and IJARRAH. The respondents are of limited or have no awareness about MUSHARKAH, SALAM, ISTISNA and ISTIJRAR. Out of these contract theories, of which the respondents are aware of, it is only TUWARRUQ contract that 10% of them claim to use, and the usage of the rest accounts for 6% and below by the respondents.

The customers were asked to rate on a Likert scale their satisfaction about the Islamic banking services. The aggregate percentage of customers, who are dissatisfied, mostly dissatisfied and highly dissatisfied accounts for 44% of the respondents. 38% of them are satisfied, mostly satisfied and highly satisfied, and the rest are neutral. On average, 18% of the respondents were highly dissatisfied compared with 14% of them who were highly satisfied. Whereas on average 17% of the respondents were neutral, and they could not rate their satisfaction about the bank services. The table below gives the bank services that score above the average 18% high dissatisfaction among the customers, services that score above the 14% high satisfaction among the customers and services that score above the average 17% neutral satisfaction among the customers.


Table 2: Customer satisfaction about the Islamic banking services Above average 18% high dissatisfaction

Above average 14% high satisfaction

Above average 17% high neutral satisfaction

- Branch Customer service counter

- Bank personal understanding of customer business

- Staff politeness with customers

- Degree of adherence to islamic principles

- Lower service charges - Complaint and suggestion

system - Convenience to access

- ATM services - Phone banking services - Confidentially - Cash & cheque deposit

ATM - Confidence in bank

management - Internet banking - Secure transaction

- Staff knowledge about the islamic banking products

- Uniform services across the branches

- Availability of financial

advice - Awareness programs on

bank service - Competitive product

offerings service charge - Convenient access

These results in the table above indicate three important things. One thing is that the average scores on dissatisfaction and neutrality are higher than the average score on satisfaction, and this implies that in general customers are not satisfied with the banking services. Another indication is that services involving interaction with the bank personnel feature prominently in the areas of customer dissatisfaction and neutrality. Whereas, services involving no or low interaction with the bank personnel, appear in areas of customer satisfaction. This implies that more automation of banking services increases the customer satisfaction, and where the services are less or not automated , the banks should employ high professional bankers in order to increase its customer satisfaction. The final indication from the above table is that there are still a good number of customers who cannot decide or judge their interaction with the banks. This implies either lack of knowledge or lack of interest in the relationships with the banks. This sizeable number of customers, who are neutral, can swing either towards dissatisfied customers or satisfied customers; and in either way the bank customer satisfaction will be sustainability affected. Thus, the banks should increase their efforts in improving their customer relation by positioning themselves distinctly as Islamic banks contrasting clearly with the conventional banks. For example, the TUWWARUQ loan transaction and the IJJARAH MUNTAHIYA BITAMLIK (lease purchase agreement) have been highly diluted, and the bank customers seem not able or convinced that it is different from an Islamic bank to a conventional bank. To make these products more Islamic, the Islamic banks can offer the customers, under the TUWARRUQ contract, the option to complete sale contract directly with a third party, instead of contracting the bank as a customer agent to execute the customer’s sale contract, obscuring the Shariah principle that the bank and the third party should be different entities. Similarly, the IJJARAH MUNTAHIYA BITAMLIK should now be used less frequently and replaced with MUSHARAKAH MUTANAGISA (diminishing MUSHARAKH). In MUSHARAKAH MUTANAGISA the customer and the bank share the ownership of the underlying asset, and the income generated by the asset is shared proportionate to the ownership in the underlying asset. Then, the sale contract is entered into whereby the customer undertakes to buy gradually the ownership proportion of the bank in the underlying asset. In this way, the principle of profit/loss sharing will be observed, whereas the IJJARAH MUNTAHIYA BITAMLIK tilts towards the spirit of the conventional finance lease. Tables 3 and 4 present the test results of the hypotheses 1 to 4, which are described under


the section of methods and hypothesis. The paper makes use of the likelihood ratio test for the row-column independence, and it follows chi-squared distribution.

Table 3: Islamic banking practice vis a vis Religious commitment, knowledge of Islam,

and knowledge of Islamic banking (hypotheses 1, 2, and 3)

Given that the respondents have Respondents’ interaction with and

views on Islamic banking Religious

Commitment

Knowledge

of Islam

Knowledge of

Islamic Banking

Having an account with Islamic bank 3.058

(0.217)

0.977

(0.807)

0.238

(0.971)

Belief that Islamic banks are different

from Conventional Banks

2.219

(0.529)

6.304 ***

(0.098) *

18.969 *

(0.001)

Degree of Shariah compliance of the

Islamic banking practice

6.652

(0.673)

3.536

(0.936)

19.488 ***

(0.077) *

Values in bracket are the asymptotic 2 sided p – values, * = significant at 1% ** = significant at 5%, and *** = significant at 10%

From the table above, the first hypothesis that says that there is no relationship between religious commitments and having an Islamic bank account cannot be rejected using likelihood ratio test at 1% significance level. Nevertheless, the cross tabulation shows that 74% and 64% respectively of those who say they have high religious committed and those who say have moderate religious commitment, have accounts with Islamic banks. The non-rejection of this hypothesis does seem to confirm the previous result. When the respondents were asked why did they open an account with Islamic bank? Majority of the respondents indicated the salary account as the most important factor for opening an account. Similarly the Islamic understanding of the respondents is insignificantly related to their holding of Islamic bank accounts. We test the hypothesis that Islamic knowledge is independent of the belief that Islamic banks are different from the conventional banks. The result is found significant at 1% level. This means the Islamic knowledge of the respondents is highly associated with the belief that Islamic banks are different from the conventional banks; around 80% of those who have excellent and good Islamic knowledge believe that the Islamic banks are different from conventional banks. The likelihood ratio test also shows there is a significant association between Islamic knowledge and the belief or disbelief in the Islamicity of the Islamic banks. 56% of those who have excellent knowledge of Islam believe the current Islamic banking practice is in compliance with Shariah, and 43% of those who have moderate Islamic knowledge believe the current Islamic banking practice is in compliance with Shariah. These percentages are in contrast to 31% and 18% respectively of those who have excellent and Moderate Islamic knowledge and believe that the current Islamic banking practice is not in compliance with the Shariah. They’re still 12.5% and 39% respectively of those who have excellent and moderate Islamic knowledge and they cannot decide on the compliance of the current Islamic banking practice with the Shariah. These cross percentages imply that the current Islamic banking practice as far as the respondents are concerned is marginally compliant with Shariah. Taking the knowledge of Islamic banking of the respondents and degree of awareness of the respondents about


the Islamic banking products as independent variables, we test whether or not they are associated with their responses on the degrees of Shariah compliance of 8 Islamic banking products as illustrated in the table below:

Table4: Islamic banking products vis a vis Awareness of Islamic banking and knowledge of Islamic banking ( hypotheses 3 and 4)

Given that the respondents are Respondents views on the

Shariah compliance of the

product

Aware of Islamic

banking practice

Knowledgeable of Islamic

banking

Personal Finance 10.734

(0.097)***

5.118

(0.745)

Real estate finance 13.947**

(0.030)

5.214

(0.735)

Car finance 16.326

(0.012)

8.847

(0.387)

Education finance 9.025

(0.172)

8.805

(0.359)

Trade finance 13.895**

(0.031)

10.558

(0.228)

Current account services 4.504

(0.609)

7.968

(0.4371)

Saving account services 12.081***

(0.060)

4.794

(0.779)

Investment account services 8.323

(0.215)

7.071

(0.529)

Values in bracket are the asymptotic 2 sided p – values, * = significant at 1% ** = significant at 5%, and *** = significant at 10%

We find that the knowledge of Islam is not associated with the products’ Shariah compliance; whereas, the knowledge of Islamic banking is significantly associated with four products’ Shariah compliance. These products are personal finance, real estate finance, car finance and trade finance. 62% of the respondents who claim to have excellent knowledge of the Islamic banking believe that the Shariah compliance of personal finance is highly trusted, and 58% of those who have moderate Islamic banking knowledge also believe so. 25% of those who have Excellent Islamic banking knowledge believe that personal finance is not Shariah compliant, and 13 % of them say it is controversial. 36% and 45 % of those who have good and moderate Islamic banking knowledge respectively believe that the Shariah compliance of personal finance in controversial. These cross percentages can be generalized for the other Islamic banking products where the row-column association is significant. It implies again that the respondents consistently view the Islamic banking practice as marginally Shariah compliant.


Conclusion and Implications To study the bank-customer relation of the Islamic banks, the literature offers five

areas to investigate in relation to the customer satisfaction and the factors that influence their satisfaction. First, it is found that staff-responsiveness is a key determination of customer satisfaction. We find that in Saudi Arabia, customer satisfaction is high with automated banking services and low with person-to-person banking services. Second, the literature investigates the factors for Islamic banking selection and it found that religion is an important criterion for Muslims to choose Islamic banks over conventional banks, and for non-Muslims high returns have been the key factor. The respondents in our paper are all Muslims, and they too choose Islamic banks on the basis of religion. The third, fourth and fifth areas of study in relation to the bank-customer relation are customer awareness and knowledge of Islamic banking products, customer perception about the Islamic banking practice, and customers’ belief about the degree of Shariah compliance of Islamic banking practice. In general, the perception is getting increasingly positive as we move from old literature to the most recent ones (table1). The customers appear to be aware of certain Islamic banking products such as TUWARRUQ, MURABHAH and IJARRAH, and in term of usage it is only TUWARRUQ they claim to have used.The respondents of the current paper generally describe themselves as devout Muslims who have good knowledge of both Islam and Islamic banking. They believe and consider Islamic banks as different, and alternative to the conventional banks. Their selection of Islamic banks is influenced mostly by the religion, and they often do salary account business with the Islamic banks. They generally have no knowledge of the Shariah board members of the Islamic banks, but they do generally disapprove of the Shariah competence of the window Islamic banking. Most customers do not know or have limited knowledge about the Shariah compliance of the Islamic bank products. The customers are aware of MUDARBAH, MURABHAH, WAKALA, TUWARRUQ, and IJARRAH, and they are unaware of MUSHARKAH, SALAM, ISTISNA and ISTIJRAR. The only contract theory they knew and used widely is TUWARRUQ. The customer satisfaction is found to be high with the automated banking services and low with person-to-person banking services. This implies that customers are not satisfied with the personal responsiveness of the banks. The customer religious commitment is found insignificantly related to having an Islamic bank account, or the belielf that the Islamic banks are different from the conventional bank, or the degree of Shariah compliance of the Islamic banking practice. Whereas, their knowledge of Islamic banking is significantly related to their belief that the Islamic banks are different from conventional banks, and it is also significantly related to the degree of Shariah compliance of the Islamic banking practice. On the Shariah compliance of eight Islamic banking products, (table 4) around 50% of the customers believe that the products are Shariah compliant. The customers’ awareness of these products is significantly associated with the Shariah compliance of the products. The results of this paper imply that the customers are generally satisfied with the Islamic banking practice, but they want them to do more than current level because they perceive that their banking operations are just marginally Shariah compliant. The customers are also generally found to disapprove of the window Islamic banking by the conventional banks.

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Analysis Of The Efficiency Levels Of The Sharia Rural Banks In Indonesia Using The

Method Of Data Envelopment Analysis (DEA) and ITS Correlation With Camel

By Muhamad Nadratuzzaman Hosen*

& Syafaat Muhari

Abstract: The magnitude of the potential micro banking market has to make profits makes this segment important for rural banks (BPR), especially Sharia Rural Banks (SRBs). Thus, the efficiency for SRBs is required to survive amid the competition. This study used non-parametric data envelopment analysis (DEA) with the operational approach to analyze the efficiency levels of 73 SRBs during the periods of 2nd Quarter- June 2011to 1st Quarter- March 2013. The level of SRB’s efficiency can be integrated with the performance of banks which is adopted from Central Bank (BI/Bank Indonesia) criteria, namely CAMEL (Capital, Asset-Quality, Management, Earnings and liquidity). Based on the Spearman correlation, the result of this study indicated that the level of efficiency of SRBs using the DEA method has a real but weak relationship with the CAMEL. In addition, this study also showed that the SRB is less efficient than Sharia Banks (BUS).

JEL Classification: E58, G21, G28

Keyword: Efficiency, Data Envelopment Analysis (DEA), CAMEL, Islamic Rural Banks

I. Introduction Banks for rural area, as part of the banking system, contribute a great deal to

Indonesia’s economic system. The existence of the SRB has a special purpose which is to cater the needs of the low income people and for the small and micro enterprises, both in urban or rural areas. In general, an SRB has a purpose and the characteristics that are similar to other micro financial institutions. Micro Financial Institutions have two * Author s: Muhamad Nadratuzzaman Hosen and Syafaat Muhari, State Islamic University of

Syarif Hidayatullah Jakarta, Indonesia. ([email protected]), [email protected])


purposes that have to be accomplished all at once. Firstly, the commercial and secondly that of human capital development. For commercial purpose means that micro financial institutions must obtain profit in order for their activities to be sustainable and have the ability to serve customer in an escalating demand(outreach). The commercial purpose has very tight relation with the second purpose which is human capital development. The target market of the micro financial institutions is those who are not presently bankable. For that reasons, micro financial institutions has a noble mission for poverty eradication, women empowerment and serving the marginal people in the society by creating work opportunities and to assist the growth of small and medium enterprises (SME) (Buchori et.al, 2003).

The potential market of micro financial institutions is quite large since there are many SME’s that operate in as yet non-bankable areas. According to financial data from Bank Indonesia as of April 2013, the financing facilities of SME have reached IDR 569.89 trillion. This amount has grown by 15.89% compared to the same period of the previous year, which was IDR 491.71 trillion. The number of accounts of the micro financial Institutions up until the first quarter of 2013 is 9.2 million customers. The trading sector has contributed the highest number amount of financing which is IDR 280 trillion or equivalent to 49.14% of the total SME’s financing. This huge potential in financing market has not been utilized at it utmost by the Sharia Rural Banks. SRBs have the ability to distribute financing for IDR 3.75 trillion in the first quarter of 2013, which is very small amount compared to micro banking distribution which was IDR 569.89 trillion in the same period Thus the capacity of SRBs is only equivalent to 0.66% compared to the micro financial institutions.

In order to be competitive in banking industry especially in small, medium and micro banking market, Sharia Rural Banks (SRBs) should be running their activities efficiently and effectively. An SRBs competitors are, other SRB and other micro financial Institutions, but also others commercial banks that set their target market on SME and micro banking areas, which is the primary target market of SRBs. Aside from these competitors, SRBs have a new competitor as the new law for Cooperative Shop is signed, which allows the Cooperative Shop to issue Cooperative Shop Equity Bond (CSEB) which will tighten the competition in micro financing market(Info bank: December 2012).

Today, the competition in micro financing is rigid considering that in 2013 Bank Indonesia has issued a new regulation concerning the accessibility of credit facility or SME financing from commercial banks with an allocation of around 20% of their financing portfolio. Johansyah (2012 revealed that the financing competition will be stiffening due to this new regulation (Mediaindonesia.com, 25 December 2012). Therefore, we need strong, sound and well trusted SRBs to be able to escalate performance in order to be competitive in this market segment.

Efficiency is one of the popular financial performance parameters in the banking industry and is utilized by many banks since it is allows calculating the performance measurements of the banking system. The operational efficiency ratio (OER), is an often used model for measurement of efficiency. The formula for OER is operating expenses divided by operating revenue. This ratio stands out since it is simple in its calculations. Yet the operational efficency ratio (OER) ratio has a frailty in generalizing whether it is a good or a bad ratio or whether a particular company or an institution is strong or weak as it does not take into account the cost of capital Expenditure (Endri, 2008).


Moreover, the CAMEL Ratio which is often use to measure a bank’s soundness is lacking in efficiency factor, since the weight of efficiency factor in CAMEL ratio is around 10% to 15% as prescribed by Bank of Indonesia Several studies have been conducted to examine the correlation between the efficiency of banks with bank soundness using the CAMEL model that show a weak relationship, Kusumawardani et. al (2008), Paramita (2008), Firdaus (2013) and Hosen & Muhari (2013). Moreover, some banks soundness category according to the CAMEL model in Hosen & Muhari research (2013) showed a very weak profitability.

In order to overcome the frailty in ratio analysis of financial performance of an institution, the frontier approach is developed to analyze the efficiency of a company. Berger and Humphrey divided the efficiency measurement through two approaches, which- are non-parametric approach and parametric approach (Berger & Humphrey, 1997). Data Development Analysis (DEA) and Free Disposable Hull (FDH) are included in non-parametric approach, while Stochastic Frontier Approach (SFA) and Distributing Free Approach (DFA) are both included in parametric approach.

According to Hadad et.al. (2003) there are three approaches in defining the correlation of input and output activities of financial institutions using the parametric or non-parametric approaches which are:

(i) Production approach which foresees the financial institution as the producer for deposits and financing; defining the output as the accounts of related transactions. Inputs in this case are calculating as the number of employees, capital expenses on fixed assets and other assets.

(ii) Intermediation approach, it foresees the financial institutions as the intermediary: modifying and transferring the financial assets from surplus units to deficit units. In this case, the inputs such as employment expenses, capital expenses and distribution of margin of deposits with the output that is measure in the form of financing facility and financial investment.

(iii) The asset approach that shows the prime function of financial institutions as the financing producers. This approach is very close to the intermediary approach whereas the output is defined exactly in the form of assets.

A different approach is revealed by Jemric and Vujcic (2002) who stated that there are two approaches that can be utilized in determining the input and output of a bank to measure the efficiency level such as Intermediation approach and operational approach. The intermediation approach is more on bank mechanism as an entity that hires people and utilizes its capital to transform the deposits into financing facility and bonds. In the meantime, the operational approach emphasized more on the perspective of expenditure and income.

The advantage of DEA compare to the parametric approach, as according to Hadad et al. (2003) is that the DEA approach does not require a large number of data, with fewer assumptions needed. Meanwhile the limitation of this approach is the non-ability to predict the unforeseen sampling errors.


Based on the above explanation, The Problem Identification to be Discussed are:

1. What is the level of efficiency expenditure of SRB in Indonesia for the Period of June 2011 – March 2013 based on the non-parametric approach of data envelopment analysis (DEA).

2. Which component influences the efficiency expenditure of SRB in Indonesia using DEA.

3. How far does correlation exist between the expenditure efficiency levels of SRB with the trustworthiness level of SRB which is reflected from CAMEL analysis.

The Objective of the Research is: 1. To analyze the level of efficiency expenditure of SRBs in Indonesia for the Period

of June 2011 – March 2013 based on the non-parametric approach of data envelopment analysis (DEA).

2. To analyze which component influences the efficiency expenditure of SRB in Indonesia using DEA.

3. To analyze the correlation between the expenditure efficiency levels of SRBs with the soundness of SRBs which is reflected from CAMEL ratio analysis.

II. Literature Review The research concerning the efficiency of SRB using the method of data

envelopment analysis (DEA) has been done in several countries, among others by Khankhoje (2008) which researches the efficiency level of rural bank in India before and after the restructuring in 1990-2002, whereas the restructuring time was within 1993-1994. This study has shown that SRBs in India have been more efficient after the restructuring. Other research has been done by Lamberte and Desrocher (2002) in the Philippines by using SFA and DFA for 50 Cooperatives Rural Banks (CRBs) for the period of 1995-1999. The result has shown that cost efficiency, efficiency of CRBs using DFA method is far more compared to SFA method and profit efficiency method of SFA is more compared to DFA.

In the meantime the research of efficiency level of SRBs in Indonesia among others has been done by Mongid and Tahir (2010) in 2006-2007 involving 41 SRBs in East Java, in which these are more efficient in in 2006 SRB in East Java compared to 2007. The same result were reached under SFA research by Nuryantono et al. (2012) whereas in 2006 SRBs in Indonesia were more efficient compared to 2007 with each SRB with efficiency value of 94.19% and 93.64%. Other research of SRBs has been done by Septianto and Widiharih (2010) which research involved 16 SRBs in the city of Semarang, the result was 10 SRBs in Semarang are not yet efficient.

The research on the correlation of efficiency level with CAMEL has been done by Kusumawardani et al. (2008) involving SRBs in East Java in 2005. The result of this research showed that the component of capital, earning and liquidity do not have the actual relation with DEA analysis. Whilst Paramita (2008) who has done research involving 1.701 SRB in Indonesia, the result has showed that efficiency, using the method of SFA and DEA, has a weak relationship and positive correlation contrary to CAMEL analysis.


Firdaus (2013) which researched 10 Islamic full-fledge banks in Indonesia for the second quarter of 2010 to the fourth quarter of 2012, using the Two-Stage Data Envelopment Analysis has shown that there is a factual different analysis between DEA and CAMEL. The same result with SFA has been found by Hosen & Muhari (2013) which research involved 59 SRBs in Indonesia for second quarter of 2011 to fourth quarter of 2012, whereas there is very distinctive result between the efficiency level using the method of SFA and CAMEL.

The research between relationship of the banks efficiency level with the soundness of banks using CAMEL models have been done in several studies. However, studies by Kusumawadini et. al (2008) only measured SRB efficiency levels in East Java Province. Paramita (2008) has conducted research on the correlation between CAMEL with an efficiency of BPR in Indonesia but the data is presented in the form of the cross section.

While the study of Firdaus (2013) assign the sample to commercial banks, Hosen & Muhari (2013) set the SRBs in Indoesia as a sample to examine the relationship between levels of efficiency using parametric method SFA with a soundness of bank using CAMEL model. This study will examine the relationship between level of efficiency of SRBs in Indonesia using the nonparametric DEA with soundness level using CAMEL model.

The advantage of DEA compared to the parametric approach, as according to Hadad et al. (2003) is that the DEA approach does not require a large number of data, with less assumptions needed. Meanwhile the limitation of this approach is the non-ability to predict the unforeseen sampling errors.

III. Research Method In this research the subject of the analysis is all existing SRBs during the period

of June 2011 to March 2013 involving 159 SRBs. The supporting data came from quarterly financial reports of the SRBs. The sampling technique for this research is done as purposive sampling based on the criteria as follows:

1. For the period of the research, all SRBs involved have produced their financial quarterly reports for 8 quarters from second quarter of June 2011 to 2013 in a complete set during the analysis.

2. The sampling is determined based on the completion of data from SRBs, mainly concerning the total expenditure, employment expenditures, cost of funds, financing, deposits in other banks, non-performing loan (NPL), capital, asset, operating expenses, amortization and net profit, and other income.

The secondary data used for this research is in the form of financial report of SRB from the second quarter of June 2011 to first quarter of March 2013 which are obtained from the website of Bank Indonesia. Based on that criterion sampling taken from 73 SRBs, Considering the high competition of banking product in micro financing SRBs should be making optimum profit with low cost. In this analysis, based on determination of the components of input and output in DEA analysis using the operational approach emphasis is more on lower cost and managing income stream. The variables in this analysis consist of the input variables (employment expense, operating expense, other expense, amortization) and output variables (operating income and other income); based


on the approach that has been used by Jemric and Vujcic (2002), Sumiryati and Diana (2007). The calculation of DEA in this research is using the software of Warwick DEA 1.03.

Further this research will investigate the relationship between the level of SRBs efficiency by using DEA method with bank soundness using the CAMEL models. Spearman analysis will be used in this study, because the results of CAMEL analysis is based on ordinal data. The assessment of CAMEL in this research is less the management assessment since the assessment must be done within the organization not from the outside monitoring. Therefore this research analysis of banking soundness is based on its financial ratios which include the component of capital, assets, earning and liquidity.

A. Data Envelopment Analysis (DEA) DEA is a linear programming technique to measure the economic activities unit

(in this case a bank) to operate competitively against other banks in the sampling. This technique created a frontier line which has been defined by the efficient bank and compared to the non-efficient banks in order to obtain efficiency values. Furthermore, the efficient bank scores are from 0 to 1, whereas number1 is the most efficient. In DEA analysis, the most efficient bank (with score of 1) does not need to produce the maximum level of outputs from the existing inputs. Moreover, the latter mentioned bank is the bank with the best practice level of outputs, compared to other bank in sampling (Yudistira, 2004:4).

DEA functions as a benchmark (Talluri, 2000, Septianto and Widiharih, 2010), first of all, since DEA produced efficiency for each bank; it is relevant to other bank in sampling. Efficiency number has the possibility that an analyst is able to identify which bank needs the most consideration and strategy to improve the efficiency levels. Second of all, if a bank is not efficient (efficiency value < 100%), DEA shows that several banks that have a perfect level of efficiency (value = 100%) and the multipliers can be used by the manager to create strategies for improvement.

The term of DEA has been introduced by Charnes, Cooper and Rhodes (1978), based on the research of Farrel (1957). For all business units in banking industry, all output and input sampling from each business unit represented by the word m and n. The calculation of efficiency level is as follows :

Whereas yis is the number of to-i which has been produce by bank to-s, xjs is the number of input to -j which has been produced by bank to-s, υiis the ouput weight νj is the input weighted. Efficiency Ratio (es) then maximize to determine the optimum weight which depends on :

Where the first un-equal equation is ensuring that the efficiency ratio becomes at least 1 and the second un-equal equation is ensuring that the efficiency weighted is positive.


Based on Charnes, Cooper and Rhodes (1978), this linear programming can be transforming into the common linear (Yudistira, 2004):

Using the same method, the program can be converted into 2 obstacles:

Whereas the ξsis the whole value of efficiency technic from bank to-s, in which the value of 1 indicated the point of frontier.

B. Bank Soundness Using CAMEL Method

A bank is generally considered as sound if it meets three criteria that include (i) the ability to maintain the interest of the public good, (ii) have the ability to develop naturally, and (iii) is useful for the development of the Indonesian economy. The components include the bank rating the quality of Capital, Management, Profitability/Earning, and Liquidity. Each of these factors is composed of one or two components which are assessed and given weight to the total rating of the bank (Bank Indonesia: 2004).

CAMEL ratings in this study is minus management assessment because it is not able to see it from the outside. Then used in this study is an analysis of the ratio of a bank's financial soundnes, which includes capital, assets, earnings and liquidity (CAEL).

CAMEL calculation of the 73 Sharia Rural Banks Sharia (SRBs) in this study was prepared by the method of calculation according to PBI Bank Indonesia. 9/17/PBI/2007 on the rating system of Sharia Rural Banks (SRBs).


Tabel 1. The Factors of the Banks assessed and Weights

Assesment Factors Component Weighted

Capital

25%

35%

Earning Asset Quality (EAQ)

10%

10%

2.5% Profitability/Earning

2.5%

Liquidity

15%

Source : PBI Bank Indonesia. 9/17/PBI/2007 about the rating system of Sharia rural banks (SRB)

Results quantification of these components were further assessed by taking into account information and other aspects that materially affect the condition and progress of each factor. Based on the assessment, five predictions of the bank’s soundness were set as follows: Very Good, Good, Fair, Poor and Very Poor.

IV. Result And Discussion A. Non-Parametric Data Envelopment Analysis (DEA) 1. Efficiency level of SRB using the method of DEA

The Result of cost efficiency of SRBs in Indonesia from the second quarter of June 2011 until the first quarter of March 2013 based on efficiency analysis of data envelopment analysis (DEA) is as follows:

Table 2 Efficiency level of Sharia Rural Bank (SRB) in Indonesia Based on efficiency

analysis Data Envelopment Analysis (DEA) in Percent (%)

SRB ID Efficiency SRB

ID Efficiency SRB ID Efficiency SRB

ID Efficiency

1 60.00 20 68.10 39 62.74 58 52.98 2 68.45 21 62.39 40 95.88 59 62.41 3 82.10 22 51.97 41 55.77 60 96.16 4 73.20 23 47.46 42 37.47 61 70.16 5 55.08 24 57.81 43 96.56 62 61.69 6 75.19 25 65.05 44 87.21 63 83.08 7 77.40 26 38.60 45 48.22 64 60.16 8 74.69 27 51.05 46 87.50 65 58.43 9 55.26 28 57.46 47 66.39 66 82.81

10 63.79 29 44.76 48 62.55 67 72.81 11 58.96 30 38.66 49 58.41 68 48.50 12 69.15 31 70.69 50 51.29 69 77.31


13 93.47 32 64.11 51 66.76 70 51.41 14 88.97 33 69.86 52 47.01 71 59.37 15 47.43 34 70.11 53 54.76 72 63.90 16 57.65 35 63.11 54 44.36 73 68.45 17 71.66 36 65.87 55 84.79 18 72.25 37 89.76 56 43.72 19 56.31 38 71.59 57 91.49

DEA Average 65.23 Source : Publication Report of Indonesia Banks in 2013 – Central Bank of Indonesia : processed data by authors

From the above data, it is known that the level of efficiency of the SRBs in Indonesia for the period of second quarter of June 2011 until first quarter of March 2013 is 0.6523 or equivalent to 65.23%. This means that the average SRB, if producing its output on the efficiency frontier instead of at its current location, would have needed only 65.23% of the inputs currently being used. Moreover, the classification of efficiency level have been divided into 4 categories using the percentile quartile and standard deviation (Paramita, 2008):

1. Efficiency Score of < 0.65 = non-efficient. 2. Efficiency Score between 0.65 – 0.76 = less efficient. 3. Efficiency Score between 0.76 – 0.87 = quite efficient. 4. Efficiency Score of> 0.87= efficient.

Based on the graph 1, SRBs with the highest level of efficiency, based on efficiency analysis of data envelopment analysis (DEA), have an efficiency score of around 0.76 – 0.87 which is about 8% or 6 SRBs. In the meantime the 19 SRBs or 26% have efficiency score of 0.65 – 0.76. The SRBs which are not efficient with efficiency score of under 0.65 relating are 39 SRBs or 54%. The SRBs that have efficiency score of more than 0.87 are 9 SRBs or 12%.

Graph 1 Efficiency level of Sharia Rural Banks (SRBs) in Indonesia

Based on efficiency analysis Data Envelopment Analysis (DEA)

Source : Publication Report of Indonesia Banks in 2013 – Central Bank of

Indonesia : processed data by authors

Sharia Rural Bank (SRB) Dinar Ashri (ID 43) has a higher level of cost efficiency at 0.9656 or 96.56%. The result shows that SRB Dinar Ashri is very cost efficient, the lowest score is SRB Unawi Barokah (ID 42) with efficiency score of


0.3746 or 37.46%, showing that this SRB is not cost efficient. Based on Table 2 from 73 Sharia Rural Banks (SRBs) in Indonesia based on efficiency analysis using data envelopment analysis (DEA) there are variations of score of efficiency ranging from 0.3746 up to 0.9656. This condition has obviously shown that each SRB has distinctive management strategy in the matter of cost efficiency on profit sharing, employment cost and benefit, in providing its information technology and other services.

2. The accomplishment of efficiency level for each variable of DEA SRB Graph 2

The level of accomplishment of efficiency of SRB

Source : Publication Report of Indonesia Banks in 2013 – Central Bank of

Indonesia : processed data by authors

The efficiency level of input and output of SRBs is shown on Graph 2. The average level of input depreciation has been fluctuating during the period of this research, whereas in the first quarter of 2012 and first quarter of 2013 each one of the input reached the number of 54% and 52.7% respectively. In the meantime, the profit-sharing income is one of the components of variable input that achieved the highest level of average result of the efficiency level during the research period with the average efficiency of 82.53%. Profit sharing expense, employee’s expense and other operating expense and other income from operations, the average efficiency level was 74.53%, 74.11% and 72.92% respectively, during the period of the research.

3. Weighted average for each Variables of DEA of SRB Graph 3

Weighted average for each variables of DEA SRB

Source : Publication Report of Indonesia Banks in 2013 – Central Bank of Indonesia : processed data by authors

The weighted average for each variable against DEA SRB is shown on Graph 3. The profit sharing income is a variable that contributes a great deal to weighted average of efficiency of SRB with the percentage amount of 34%. The large amount weighted average of this efficiency is considering that the SRB offered higher margins to


customers who applied for financing facilities compare to Islamic full-fledge banks and Islamic windows.

Table 3 Comparison of margin between

For Full Fledge Islamic bank and SRB as of June 2013

Financing Facility (FFIB) Financing Facility (SRB)

Type of aqad Margin (%) Type of Aqad Margin (%)

Mudharabah 14.93 Mudharabah 17.34 Musyarakah 12.32 Musyarakah 21.81 Murabahah 13.56 Murabahah 18.89 Istishna 14 Istishna 7.51 Ijarah 0.41 Ijarah 13.22


Since the margin is higher, thus the margin is considered as an output component which contributes a large scale of efficiency level of DEA SRB. Whilst the other output components such as other operating income have contributed the smallest output which was 5% which reflected that SRB has not been maximizing its effort to improve fee based income.

The input components of other operating expenses such as administration and general expenses, allowances for losses of assets, wadiah expenses and other operating expenses, has contributed the second largest weighted average to the efficiency in input components which was 21%. A large portion for both variables for the input components required the SRB to increase the quality of its human capital and to improve its management team to operate more effectively. Moreover, there are two more variables in this input component, the margin expense and the depreciation which contributed to the efficiency weighted average by 8% and 6% respectively.

B. Mapping the Efficiency Level of SRB using the Non-Parametric DEA Graph 4

Mapping the efficiency level of SRB based on category using the Method of DEA


Keterangan* :

Asset Category 1 : < 10.000.000 Category 2 : 10.000.000 – 50.000.000 Category 3 : > 50.000.000

POF Category 1 : > 7% Category 2 : 3% - 7% Category 3 : < 3%

EOTA Category 1 : > 30% Category 2 : 20% - 30% Category 3 : < 20%

NPF Category 1 : > 7% Category 2 : 3% - 7% Category 3 : < 3%

Financing Category 1 : < 10.000.000 Category 2 : 10.000.000 – 50.000.000 Category 3 : > 50.000.000

Profit Category 1 : < 500.000 Sharing Category 2 : 500.000 – 2.500.000 Category 3 : > 2.500.000

TC Category 1 : < 1.000.000 Category 2 : 1.000.000 – 5.000.000 Category 3 : > 5.000.000

POB Category 1 : < 1.000.000 Category 2 : 1.000.000 – 5.000.000 Category 3 : > 5.000.000

POL Category 1 : > 6% Category 2 : 3% - 6% Category 3 : < 3%

*In thousand Rp (IDR). *Source : Central Bank of Indonesia : processed data by authors

Based on the above graph, the efficiency level of SRBs using the data envelopment analysis (DEA) based on asset group, financing, deposit with other banks is in line with the efficiency value of SRB, which means that the greater the value of the three variables, the more efficient that particular SRB. This has indicated that most SRB have not reached economies of scale. Just like the total assets, a large amount of margin and the total cost has shown the same effect as they are in line with the efficiency level.

The economies of scale of SRB that has not been reach among others is because the lack of support of its ICT, non-effective management performance and in-competent human capital (Rahardja and Manurung, 2006). In order for SRBs to develop economies of scale, they will need sufficient amount of capital. The capital can be invested for the improvement of human capital and ICT; it can also be used as the benchmark to increase the legal lending limit amount of financing facilities in order to provide more services to a wider customers base.

The above graph 4, shows that Sharia Rural Bank (SRB) based on its human capital value/price of labour (POL) for the first, second and third category, no SRB group has efficiency level above 75%. It demonstrates that the human capital of SRB in Indonesia is not maximizing its work effort and the Technology used is not sophisticated yet. Therefore the SRB can maximize its efficiency level only if it could improve its human capital and Technology.

For that reasons, Bank Indonesia (BI) and Financial Service Authority (FSA) should train and monitor the performance of SRB in order to improve the quality and the integrity of its management, including supporting the management of SRB to practice good corporate governance (GCG). Apart from that, the revitalization of new technology is needed for the SRB to operate efficiently in order to cut operating cost and cater the need of competitive services to its customers.

Bank Indonesia (BI) and Financial Service Authority (FSA) are to ensure there is a guarantee for fair competition in micro banking services. In general, Islamic full-fledged banks have the advantage in term of Capital Adequacy Ratio, Technology and Human Capital compared to SRB. BI and FSA need to stimulate the full-fledged banks to channel their financing using the intermediation channel of SRB. This intermediation could be done by activating the linkage program through executing (SRB received funds to be distributed to its customers), or channeling (SRB acting as agency) and joint financing between SRB and Full-Fledged bank. Full-Fledged bank becomes a business


partner for SRB is one solution that would sustain the development and growth of SRB in micro banking products and services.

Yet, the linkage program between the Commercial Banks and SRBs will be difficult to apply since there is still a high risk of channeling the financing facility of SRB. This was reflected from the ratio of nonperforming financing (NPF) of SRB which is quite high during the period of 2007 – 2012, at around 7.56% which indicate that there is a high non-productive qualification of asset. Furthermore, BI and FSA should improve and monitor the SRB to apply its prudential banking rules. in

C. CAMEL Analysis of Sharia Rural Bank in Indonesia Aggregating on basis of CAMEL model, SRB in Indonesia in March 2013

period ranked 1 with very good prediction, it means the bank has a good capital quality and excellent management, supported by asset quality, profitability and liquidity adequacy and very low sensitivity to market risk (see table 6 in attachment).

Capital components in CAMEL model represented by the Capital Adequacy Ratio (CAR) showed that the average CAR of SRBs in Indonesia is 35.22%. CAR of SRBs is still within prescribed limits of Bank Indonesia which is set at a minimum CAR of 8%. The magnitude of this CAR indicates that the SRB has had a very strong capital condition that includes both current and solvency requirements for future periods. (Bank Indonesia: 2004).

Asset quality components in CAMEL model represented by Earning Assets Quality (EAQ) and Non-Performing Financing (NPF) showed that the average EAQ and NPF of SRBs in Indonesia is 93.46% and 10.07% respectively. EAQ and NPF of SRB is still within prescribed limits of Bank Indonesia, which is a minimum 87% of EAQ and maximum 13% of NPF. Asset quality of SRBs during this period showed that the SRB has good asset quality generally and quite good on specific exposures of major customers. (Bank Indonesia: 2004).

Earning component of CAMEL model represented by Operational Efficiency Ratio (OER), Return on Assets (ROA) and Return on Equity (ROE) showed that the average of OER, ROA and ROE of SRB in Indonesia is 63.87%, 2:43% and 31.17% respectively. OER, ROA and ROE are within prescribed the limits of Bank Indonesia where OER is a maximum of 87%, ROA a minimum of 0.999% and ROE of at least 13%. Components of earnings of SRBs in this period showed that the SRBs have a level of benefits and value added distribution very well supported by the very high level of operating efficiency. (Bank Indonesia: 2004).

Liquidity component of CAMEL model represented by the Cash Ratio (CR) indicates that the CR average of SRBs in Indonesia amounted to 27.8%. CR of SRBs is still within prescribed limits of Bank Indonesia where CR is set at least 3.3%. Liquidity component indicates that the SRB has experienced a degree of probability that a short term low mismatch is supported by liquidity contingency management in the face of a liquidity shock very well.

Although the average of overall SRBs in Indonesia showed that the SRBs are sound, but components of Capital, Earnings and Liquidity have a high standard deviation. This means that there is a high difference between the conditions and uneven


performance of one SRB with the otherSRBs. The standard deviation for components of CAR were 67.49%, 45.53% OER, 117.9% and a ROE of 97.2% CR.

D. The Relationship between efficiency Level of DEA with CAMEL Analysis Ratio The ratio calculation of CAMEL of 73 SRBs in this research is based on

calculation compiled by Bank Indonesia under the Bank Indonesia regulations PBI No. 9/17/PBI/2007 of the assessment system of banking soundness of Sharia Rural Bank (SRB). In this linearity DEA to CAMEL we will use the correlation of Spearman since data of CAMEL which is used is the ordinal data as the outcome of quantitative and qualitative ordinal data such as the value of 1 for the SRB which has the best category and value of 2 for the SRB which has good category and so on.

Table 4 Correlation of Spearman DEA to CAMEL

DEA CAMEL

Spearman Correlatian 1 -

Sig. (2-tailed) DEA

N 73 -

Spearman Correlatian -0.353** 1

Sig. (2-tailed) 0.002 CAMEL

N 73 73 ** Correlation is significant at the 0.01 level (2-tailed). Source: processed data by authors

Based on the above table, the relation of efficiency level of DEA versus the bank soundness analysis by using the CAMEL is actual since sig. < α (0.002 < 0.01). The value of DEA and CAMEL have a negative and very weak correlation which is -0.353. The correlation between DEA and CAMEL is interpreted as the larger the DEA value of efficiency of a particular SRB, it will follow by the soundness of SRB which has been shown by the declining value of CAMEL (the value of 1 is the smaller number and it is the best category of bank soundness).

This research is not in line with the research done by Kusumawardani (2008) whereas the 3 component from the CAMEL: capital, earning and liquidity do not have actual correlation with DEA analysis. Furthermore, this research is not in line with the research done by Hosen & Muhari (2013) and Firdaus (2013) whereas there was a significant differentiation between the efficiency value using the frontier method and using the CAMEL model. Iit indicates that the soundness level of bank using the CAMEL method is not reflected the efficiency level of that particular SRB, yet this research is in line with research done by Paramita (2008) whereas the efficiency level of SRB using the method of DEA has an actual correlation.

The weakness of correlations between DEA and CAMEL is since the measurement of bank soundness using the CAMEL ratio analysis does not consider efficiency as the primary factor (only 10% out of the whole ratio) thus we have seen that there are many SRBs that are less efficient but have a higher score in CAMEL analysis compared to the SRB that is more efficient.


1. Distribution of efficiency level of DEA VS the CAMEL Criterion Graph 5

DEA Distribution of CAMEL

Source : processed data by authors

Based on graph 5 above it is shown that there are 39 SRBs which are not efficient based on DEA calculation and there are 6 SRBs that fall in poor category. But according to CAMEL analysis, there are 3 SRBs considered fair with fair efficiency level, there are 22 SRBs falling in good category and the rest 8 SRBs are very good. From SRBs that are less efficient based on DEA calculation, there are 2 SRBs that are fair, 6 SRBs good and 11 SRBs are very good. From SRBs that are quite efficient based on DEA calculation, there is 1 SRB that is quite good, there are 4 SRBs that are good and 1 SRB is very good. Furthermore, there are 9 SRBs that are efficient based on DEA calculation and 1 of these is quite good, there are 4 SRBs in good category and there are 4 SRBs in very good category.

The result of the comparison is quite interesting for measuring the efficiency level of SRBs using the DEA approached, with 8 SRBs at very good, 22 SRBs good based on CAMEL analysis. The soundness calculation of SRBs based on CAMEL model by Bank Indonesia, considered as the criterion is somewhat not relevant to the case of SRBs as SRBs is considered as small banking business.

2. CAMEL Analysis as alternative for the solution to measure the soundness of banking system. The analysis of CAMEL in so far as having become the benchmark in measuring

the soundness of the banking system should be reassessed, especially in determining the weighted average of its component. In determining the weighted average of CAMEL of the SRBs, as according to PBI No. 9/17/PBI/2007 concerning system of measurement of the soundness of rural bank based on the principles of Shariah, the efficiency component reflected from operating expense to operating income ratio, the weighted component is only in a small portion which is around 10% to 15%. Therefore, the weighted average in CAMEL should be reassessed to consider the efficiency levels.

To maximize the calculation of efficiency level in CAMEL analysis, the component of operating expense to operating income ratio which reflects the efficiency factor should be replacd by the frontier approach in new CAMEL weights. The


replacement of operating expense to operating income ratio with frontier approach is to be done considering that there is a limitation in operating expense to operating income ratio. In this research the frontier approach used is the non-parametric data envelopment analysis (DEA) approach. Therefore, we have attempted to create 3 models of CAMEL with additional description as follows:

Table 5 Differentiate weighted average of several Models of CAMEL

Factors Component Model 1* Model 2** Model 3*** Model 4****

Capital CAR 25% 20% 25% 20% EAQ 35% 30% 35% 30%

Assets NPF 10% 5% 10% 5% Efficiency 10% 25% 10% 25% ROA 2.5% 2.5% 2.5% 2.5% Earning ROE 2.5% 2.5% 2.5% 2.5%

Liquidity CR 15% 15% 15% 15% * Based on PBI No. 9/17/PBI/2007 ** Changing The Weights *** Replaced BOPO by Frontier Approach **** Replaced BOPO by Frontier Approach and Changing the Weights

Graph 6

The Comparison value of CAMEL

Source : processed data by authors

The graph 6 above is showing the comparison of the modification of CAMEL model 1, CAMEL model 2, 3 and 4. On the Graph, Model 2 (by altering the weighted value of each component) it has shown the modification result of 5 SRBs where CAMEL criterion is higher, 66 SRBs where CAMEL criterion is stable and 2 SRBs with declining criterion of CAMEL. CAMEL Model 3 (replacing the operating expense to operating income ratio with DEA without changing the weights of each component) it has shown a significant modification compare to model 2 where replacing the weights of each of the component, as a result, in 1 SRB the criterion is upward, in 42 SRBs the criterion is stable and in 30 SRBs CAMEL criterion is declining. CAMEL model 4 (by replacing the


operating expense to operating income ratio and changing the weighted average of every component) it has shown that there is no SRB has CAMEL criterion upward, and 29 SRBs have stable CAMEL criterion, while the rest of 44 SRBs declined on CAMEL criterion.

The concept of soundness of the bank by using CAMEL as the analysis tool is created based on risk focus and to envision the future condition (forward looking) (Bank Indonesia, 2004). Hence, the bank is required to minimize the risk in order to avoid the losses and to guarantee its effort at sustainability. Therefore, most of its ratio is considering the asset quality (45% of the whole weight) and Capital Adequacy Ratio (25% of the total weight) whereas both components are used for risk management purpose.

The efficiency component that is included in CAMEL weighted average is a small portion around 10% - 15%. The component of CAR and Asset quality is merely important in order to maintain the financing quality and to maintain the soundness of the bank, yet the efficiency component which is not included in the calculation in CAMEL could damage the soundness of a bank. In SRB CAMEL calculation, for the period of March 2013, SRB that has lower efficiency level based on DEA calculation is classified as a sound bank in CAMEL calculation.

The lower efficiency level of a bank will disturb its earning which will harm it soundness, if a bank keeps experiencing in-efficiency, thus earning will decline/d. When the profits have been declining while the bank is obliged to pay the Syirkah profit to its customers, the profit earned will be lower and bank could suffer a loss. This loss could be replaced by the capital, but the declining amount in capital will have a negative impact on the Capital Adequacy Ratio and it will be a hindrance to development and growth of the SRB.

The effect of efficiency to the soundness of bank has a strong bond although it is non-direct one. For that reason the efficiency component is needed to be considered in CAMEL analysis. The consideration of efficiency in CAMEL analysis can be done by changing the existing weights of components of efficiency (operating expense to operating income ratio) and to replace the operating expense and operating income ratio with frontier calculation or the combination of both components.

Therefore the SRB can operate efficiently, more toward the prudential principles (prudential banking) and to maintain its capital sustainably. The government support of SRBs is needed in order to create a fair competition in micro banking market.

V. Conclusion And Suggestion A. Conclusion

Based on the above analysis and discussion that has been elaborated concerning the efficiency of banks for the rural area or SRBs in Indonesia for the second quarter of June 2011 until the first quarter of March 2013 based on DEA method which was then related to CAMEL analysis for the measurement of soundness of the banking system, therefore we has come to conclusion as follows:

1. The average level of efficiency of SRBs in Indonesia from the second quarter of 2011 (June 2011) until first quarter of 2013 (March 2013) by using the method of non parametric DEA was 65.23%, with standard deviation of 14.07%.

2. In the DEA method, margin is one of the output component that contribute the largest weight in bank efficiency level which was 34%. In the meantime, the input


component such as other operating expense (not including margin and employee’ expenses) both contribute quite significantly t the level of efficiency of the SRB, 26% and 21% respectively. The human capital factor of the input component and the financing factor of the output component are the dominant factors in determining the level of efficiency of SRB in Indonesia.

3. Based on spearman correlation the efficiency level of SRB using the method of DEA has a weak correlation with the CAMEL analysis of a soundness of a bank. This indicates that the CAMEL analysis of a soundness of a bank has not reflected the efficiency level of a particular SRB.

B. Suggestion 1. The management of Sharia Rural Banks (SRBs), are expected to keep improving

cost efficiency since there are some expenditures that inefficiently spent. Considering the high cost of human capital, the SRB Management must upgrade its Technology in order to cut cost to be more efficient and to improve its operational management to be operating effectively.

2. Apart from this, SRB is expected to improve its financing facilities by improving its quality and lower its NPF in order to operate efficiently. The financing component has a large contribution to efficiency level. Moreover SRB is expected to increase its fee based income since this contributed a small role for the development and growth of SRB.

3. Bank of Indonesia (BI) and Financial Service Authority (FSA) need to support the commercial bank to channel its financing through the mediation of SRB by providing the linkage program rather than executing financing directly to its customers.

4. Considering the stiff completion among the players of micro banking, there should be a regulation to limit the area of operation in order to avoid two or more SRBs to operate in the same area. The existing regulation under PBI No. 11/23/PBI/2009 has limited the area of operation for the SRB in one province, yet the regulation do not regulate the no of SRBs to be in one area. The regulation should be one SRB for one town only. In case in a town there are more than one SRB it is better if these are united through merger and acquisitions. Other implication is that SRB with strong capital will be able to expand its business.

5. With SRB condition still operating under dis-economies of scale, hence merger between two or more SRBs that are operating very close to each other in the same area, is one solution to strengthen the capital of SRB in order to accomplish economies of scale. This kind of merger is to prevent the unsafe competition among SRB that operate in one area.

6. The CAMEL Analysis Ratio, as the measurement tools for the soundness of banking system should be reassessed, especially in determining the weighted components. The consideration of the efficiency of the CAMEL analysis can be achieved by changing the existing weighted components of efficiency (operating expense to operating income ratio) and replacing the ratio calculation by Frontier calculation (SFA or DEA) or it can be done by the combination of both components.

7. For the next researcher, the efficiency level of SRB should be compare to the efficiency level of commercial bank to measure the competition among micro banking segment with the larger banks.


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APPENDIX

Table 6. Sharia Rural Bank (SRB) Level of Soundness in the March 2013 Period

ID CAR

(%)

AQ

(%)

NPF

(%)

OER

(%)

ROA

(%)

ROE

(%)

CR

(%) CP SOUND

CRITERION

1 17.53 93.37 9.26 50.41 2.98 1.54 2.58 1.65 GOOD

2 23.37 99.05 1.80 39.47 1.78 -18.3 1.86 1.7 GOOD

3 17.08 98.21 2.62 39.94 1.16 22.68 1.16 1.68 GOOD

4 7 96.35 6.16 87.91 -0.71 -12.8 3.86 2.55 FAIR

5 -9 84.83 25.19 405.8 -17.51 -5.43 45 4.05 POOR

6 28.4 98.89 1.70 43.56 6.08 33.2 8.29 1 VERY GOOD

7 16 94.57 9.58 68.22 1.18 14.65 0.62 1.8 GOOD


8 25.1 93.91 10.48 52.43 1.66 17.78 0.81 1.85 GOOD

9 29 96.64 6.59 78.03 -0.09 -1.79 0.81 1.8 GOOD

10 14.25 99.83 0.26 52.86 3.44 69.79 0.43 1.6 GOOD

11 25.51 93.17 13.06 58.2 1.41 2.21 0.67 2.03 GOOD

12 22.6 95.1 9.89 49.05 1.18 6 4.28 1.4 VERY GOOD

13 26 97.52 4.66 32.25 0.53 680 2.89 1.55 GOOD

14 9.59 76.23 36.89 36.63 0.04 0.47 4.98 3.25 FAIR

15 42.63 92.35 18.86 98.2 -5.96 -147 1.86 2.95 FAIR

16 50 66.1 58.73 0.564 -6.19 -23.3 0.47 3.6 POOR

17 78.54 77.18 39.76 75.27 2.28 8.92 9.5 2.88 FAIR

18 13 93.31 12.57 47.57 3.29 36.55 163 1.2 VERY GOOD

19 14.91 97.28 5.80 61.28 0.93 9.46 1.07 1.75 GOOD

20 14.14 97.11 5.51 47.08 6.17 112.6 0.65 1.6 GOOD

21 7.2 62.8 55.96 63.42 -1.34 -19.9 1.89 4.35 POOR

22 11.57 97.38 3.81 52.77 3.55 44.9 0.63 1.6 GOOD

23 19 96.79 5.53 62.51 0.11 0.38 1.62 1.8 GOOD

24 11.51 96.69 5.87 42.38 0.36 4.26 7.05 1.2 VERY GOOD

25 13.37 88.94 22.4 63.25 -0.46 -8.69 5.62 2.3 GOOD

26 11 98.89 2.36 60.7 -0.57 -2.18 1.02 1.8 GOOD

27 21 88.48 21.4 81.46 -0.02 -0.27 527 2.3 GOOD

28 11.58 96.07 7.64 58 -0.3 -4.84 1.33 1.9 GOOD

29 16.52 98.22 3.48 41.79 19.65 61.76 9.56 1 VERY GOOD

30 11.91 98.71 2.83 77.23 -0.13 -1.54 0.55 1.8 GOOD


31 13.5 98.48 2.3 50.69 0.37 5.83 0.8 1.8 GOOD

32 44.81 97.58 3.5 43.03 1.57 7.77 172 1.1 VERY GOOD

33 14.34 94.24 11.2 56.57 2.62 56.96 1.64 1.8 GOOD

34 22.54 98.18 2.68 44.82 7.57 38.23 7.23 1 VERY GOOD

35 24 95.09 9.36 69.23 1 5.3 19.9 1.25 VERY GOOD

36 110.3 97.69 4.1 40.63 4.36 42.07 1.98 1.6 GOOD

37 83.74 97.93 2.97 36.2 6.32 52 1.12 1.6 GOOD

38 15.97 92.89 9.49 42.36 3.99 34.91 33.7 1.45 VERY GOOD

39 24.93 96.51 6.56 84.33 2.49 10.91 1.82 1.78 GOOD

40 571.7 95.92 6.89 89.98 5.75 9.24 5.19 1.48 VERY GOOD

41 35 96.48 7.28 56.97 11.98 51.79 5.7 1.1 VERY GOOD

42 39.12 98.39 3.64 121.7 -2.07 -7 6.47 1.6 GOOD

43 32 98.51 3.89 66.9 2.85 3.59 30.3 1.1 VERY GOOD

44 33.84 97.87 3.62 33.48 6.89 38.2 25.1 1 VERY GOOD

45 51.76 82.54 21.7 86.91 4.97 15.26 11.2 3.05 FAIR

46 79 97.07 4.69 40.89 0.92 3.26 2.8 1.63 GOOD

47 85 98.44 2.1 46.5 1.09 2.47 12.5 1.15 VERY GOOD

48 10 89.31 18.4 110 -1.92 -31 17 2.95 FAIR

49 23 95.51 6.81 62.56 0.6 5.01 622 1.2 VERY GOOD

50 26 91.92 14.2 73.37 0.5 2.14 5.42 1.85 GOOD

51 9 99.45 0.95 53.61 2.74 62.12 0.65 2.1 GOOD

52 0.31 92.57 15.3 83.2 -0.11 -1.35 0.48 3.55 POOR

53 54 96.81 8.87 70 0.36 -2.58 25.4 1.3 VERY GOOD


54 22 92.69 11.8 114 -2.51 -15.1 64.4 2.15 GOOD

55 43.13 88.48 16.4 59.62 3.92 7.58 0.44 2.8 FAIR

56 37.96 90.96 13.8 72.09 1.54 3.82 0.78 2.35 GOOD

57 39.96 99.72 0.5 41.22 3.4 19.47 1.25 1.63 GOOD

58 17 71.32 41.7 79.98 -0.42 -7.4 0.73 3.6 POOR

59 102.3 92.28 10.8 46.45 8.74 26.92 2.71 2 GOOD

60 14.49 96.78 3.69 30.71 4.3 35.7 4.64 1.15 VERY GOOD

61 14 96.16 7.51 36.14 0.11 1.06 13.4 1.3 VERY GOOD

62 34 76.87 28.3 63.53 0.42 0.75 0.48 3.6 POOR

63 23.34 91.61 9.18 42.63 0.33 1.72 35.7 1.65 GOOD

64 15.07 94.42 7.06 68.08 5.02 64.04 0.37 1.7 GOOD

65 22 93.92 9.05 76.2 2.81 21.47 0.64 1.73 GOOD

66 15.45 97.22 4.98 39.59 1.33 16.76 1.56 1.68 GOOD

67 14.45 97.53 3.9 47.96 42.4 728.1 30 1 VERY GOOD

68 12.4 95.63 7.88 56.61 0.68 7.97 0.8 1.9 GOOD

69 22 97.02 4.86 50.02 5.05 38.43 9.94 1 VERY GOOD

70 37.43 94.05 7.08 76.6 1.29 8.85 0.32 1.8 GOOD

71 33.47 99.39 0.69 57.07 8.08 18.53 0.98 1.63 GOOD

72 15.29 97.83 3.63 47.3 0.66 6.57 9.1 1.2 VERY GOOD

73 31 95.11 8.94 64.77 0.91 4.14 26 1.28 VERY GOOD



An Application of Shariah Contract on Islamic Retail Investment Products: An

Overview on Malaysia Practice By

Ahmad Aizuddin Hamzah* Farah Shazwani Ruzaiman

Haneffa Muchlis Gazali

Abstract The Islamic investment deposit product is one of the tools which increases the capital source of the Islamic financing facilities. As an alternative to the conventional interest-based investment deposit product, the Islamic bank used the profit sharing analysis or also known as mudarabah contract for their investment product. But, despite a few issues with mudarabah investment deposit product and additional rules of the Islamic Financial Service Act 2013 on the Islamic deposit product, many Islamic bank looks at other alternative on their investment deposit facility. Therefore, the introduction of commodity murabahah or tawarruq-based deposit could be the best alternative to take its place. Hence, this paper aims to explore the current Islamic deposit products which are available in Malaysia market. The discussion will include the shariah contract used, the product mechanism and framework and the differences.

KEY WORDS: Mudarabah, Islamic Finance, Investment Products, Islamic Banking

Introduction The word “investment’’ is usually defined as the creation of income activities

which develop the economic growth of the society. These not just benefit the big corporations or high income earners, but also helping those low income and non-profit organization as part of their financial objective. As a financial intermediary, a bank plays a vital role to provide a financial adviser to the public especially on the part of income

* Authors: Ahmad AizuddinHamzah, Farah ShazwaniRuzaiman, Haneffa Muchlis Gazali

are Lecturers, Islamic Finance, Universiti Malaysia Sabah, Labuan, Malaysia, E-Mail: [email protected], [email protected]


growth. Today, there are a lot of products or financial instruments available for investment activities which consist of both short and the longer term maturity. Term deposit, also known as fixed deposit in conventional banking is one of the investment tools for the retail banking segment. With short term investment purposes, this product gives more choice to its client on the part of maturity period, such as monthly, 3-months, 6 – months and twelve months ( a year) and the return rates are in accordance with the investment period. Besides that, the Term deposits also function as a part of capital contribution for the banks source of funds.

As the product have a pre-determined profit rate at the start of the contract, thus, it is found to be contradictory to the philosophy of Islamic law. Besides rejecting the pre-determined profit rate for the investment, an Islamic bank which is fully guided by the Shariah law will by trade and profit determine the rate of return for the investment products and used the concept of profit and loss sharing for the venture (Mirakhor & S. Khan, 1989). Mudarabah contract was used for the Islamic investment product as the nature of the contract is based on profit sharing. The Islamic bank acts as an entrepreneur while the depositor is responsible for the capital contribution parts. Any profit made on the venture will be shared among the parties based on the pre-agreed ratio, while the losses are only borne by the capital contribution or depositor subject to no mistake by the bank.

Mudarabah General Investment Account (MGIA) is the commercial name for the Islamic investment product which currently exist in the Islamic banking market of Malaysia. After more than 20 years the establishment of Mudarabah General Investment Account, there are few issues and debates with regard to the Shariah law. On top of that, the new rules of the Islamic Financial Service act 2013 put this product under more pressure as the new guideline states that, only such contracts such as qard, murabaha,wadiah and tawaruq can be used on the liability side of the Islamic banking balance statement (Ghafar&Nik, 2013). Most of the Islamic banks in Malaysia thus are looking for the alternative for the Islamic deposit product after the new rules have been imposed.

The Commodity Murabahah Deposit (CMD-i), also referred as Tawaruq term deposit looks more suitable for the solution of the Mudarabah deposit investment product. This paper is based on theoretical analysis which aims to discover more details on these two products and discuss the different features available.

The Difference Between Mudarabah General Investment Account and Commodity Murabahah Deposit i. Mudarabah General Investment Account-i

Islamic banking avoids any interest-bearing deposit account as a payment of interest is forbidden from the Shariah law perspective. For the purpose of trade and earning a profit, Shariah law imposes a profit sharing mechanism as its primary business model. This operation looks more just and fair to the society as compared to the interest concept. The profit sharing concept which is the main operation of the Islamic business model, usually uses the contracts of Mudarabah and Mushyarakah partnership.

The contract of mudarabah can be simply explained as a meeting point of the capital contribution partner and the entrepreneur who will share the profit from the investment or project according to the capital ratio as per terms agreed on in the contract. According to Simon Archer & Rifaat Ahmed (2009), mudarabah contract is a relationship


between capital and work where one party acts as an entrepreneur or mudarib for the venture and the other partner is responsible to contribute the capital and act as sleeping partner. The concept of mudarabah is also supported in the Quranic verses as stated in verse 20 , al-Muzamil:

‘’….others travelling through the land, seeking of Allah’s bounty…’’

The nature of profit sharing and the element of investment activities in the Mudarabah contract seems to be ideal to replace the interest-mode deposit. Based on the Shaed for mudarabah in Islamic banking is investment deposit. Thus, the product named as Mudarabah General Investment Account (MGIA) and Mudarabah Special Investment Account (MSIA) which apply to all the Islamic banks in Malaysia is the investment deposit product purely under the review of Shariah.

A Mudarabah general investment account provides an investment opportunity that operates under the contract of Mudarabah. The Mudarabah contract is a partnership contract whereby the depositor or customer is known as rabbul mal who is seeking the investment opportunity and will invest through the bank that is known and acts as mudarib and manages the funds. The partners will share profits according to the earlier agreement. Some examples of the profit sharing ratio are 40:60, 50:50, 70:30 and the profit to be shared depends on the bank’s performance.

Under the general investment account, there is no minimum tenure of investment. The mudarib has a broad range to invest and trade on the basis of trust and expertise they have acquired.

Figure 1: The Mudarabah Contract Process

Based on figure 1, below are the explanations of the Mudarabah contract process:


1. Depositor and bank agree on the terms of Mudarabah and profit-sharing ratio. The depositor then provides funds to the bank.

2. The bank invests the funds and manages its operation.

3. The profit generated by the investment will be shared between the parties based on the pre-agreed ratio. In the event of loss, the depositor as an investor will bear all the losses and the bank will lose the resources spent.

ii. Commodity Murabahah Deposit Murabahah literally means a sale on mutually agreed profit. The words are derived

from the Arabic root ribh which mean gaining or profit. In English, the word is of often referred to as mark-up, or cost plus-financing (Khan, 2008). Commodity Murabahah is one of the financing products offered by Islamic banking by using financing contracts. This product fall under similar generic category of “Bai al-Amanah” and it is from major category of “uqud al-mu’awadhat” (exchange contract) which covers all types of transactions including sukuk. In the basic business transaction of Murabahah, the bank initially will buy certain tangible asset, then sell it to the client who wants to own that asset. Technically, in the case of commodity murabahah, bank will buy certain commodity from a broker and sell to the client who does not want to own the commodity, therefore, they sell the commodity to another broker to get cash. There are several types of Murabahah contracts being practiced by modern Islamic banks such as Simple Murabahah, Agency Murabahah, Murabahah to purchase order, Tawwaruq and Bai al-Inah. The developments of Islamic banking in this particular product raises the quandary among the Islamic banking users, who claim that the commodity murabahah is against the Islamic norms. However, according to Alsayeed (2010), on the basis of principle murabahah does not violate the Islamic norms. He emphasized that commodity murabahah covers all the type of exchange contracts which are permissible in Islam. In such transactions, the exchange contract gives certain quantity of one commodity traded for a given quantity of another commodity, including money.

Commodity Murabahah Program (CMP) was introduced in Malaysia as an initiative of Bank Negara Malaysia to support Islamic financial institutions in order to facilitate liquidity management and for investment purposes. This cash deposit product is based on the tawwaruq principle. The term Tawwaruq comes from Arabic words wariq which means character or symbols for silver. However, tawwaruq also given a wider meaning in seeking cash by various means such as gold, silver etcetera. Basically, tawwaruq is a process of sale contract whereby at first a buyer buys an asset from a seller with deferred payment and simultaneously sells the asset to the other party for cash with a price lesser than deferred price for the purpose of obtaining the cash. According to the rules developed by fuqaha, the purchase price in the transaction must be known and the successive selling must be clarified especially to an intermediary (Khan, 2008). Besides, it is necessary for the commodity to be purchased and taken into possession, physical and constructive by the bank in Shariah-compliant murabahah. Therefore, it is assumed that the risk of the commodity will remain under bank possession and ownership. The tawwaruq concept is quite similar to bai al-Inah based instrument due to both sharing the same substance and consequences. Yet, the major difference between these two instrument are that there is a third party intermediary present in the concept of tawwaruq and in the case of bai al-Inah, the object is returned to the original owner whereby in tawwaruq that kind of conditions does not exist (Bank Negara Malaysia).


Even though bai al-Inah transaction has been disallowed by the past jurists from Malikis and Hambalis schools, yet these scholars do not reject the tawwaruq outright. This principle has been long discussed among the Shariah scholars worldwide and it was officially endorsed as a permissible instrument and practically implemented since 28th July 2005 (Bank Negara Malaysia, 2007). The features of CMP is that this product provides certainty of return based on pre-agreed ‘margin’ and ‘mark-up’ from the sale and purchase of the underlying asset. The ulama also permit tawwaruq based on Quranic verses and fiqhiyah methods that say that all trading are permissible as long as it is halal except transactions that involved haram- including the qualities guided by the Quran and Sunnah. On that basis, tawwaruq is halal transaction because it does not include any dispute prohibiting trading transactions.

This programme was also available in the Islamic investment retail deposit. Tawaruq term deposit –I or also called as commodity murabahah deposit-I is one of the alternative for the Islamic investment account. The usage of tawaruq contract for liquidity management was also actively conducted in the Middle East Countries. In the case of Malaysia, the commodity used for the tawaruq transaction is Crude Palm Oil (CPM) which is managed by the Bursa Suq al-Sila’. Due to the high demand of the products, the underlying asset was extended into several types of commodities which are telecomincation air time, Condensed Milk and etc.

Figure 2: Commodity Murabahah Programme Structure and Mechanism for Liquidity

Figure 2: Commodity Murabahah Programme Structure and Mechanism for Liquidity Absorption

(Source: adopted from Ismail, Ghani and Zain, 2013)


The mechanism of CMP for absorbing liquidity is illustrated in Figure 1 describe as follows:

(a) For the purchase transaction worth of RM100k, a customer should appoint the bank as an agent to them.

(b) During the transaction, customers should pay the purchase price immediately, while signing the contract with the purpose of the purchase transaction.

(c) On the same day or it can be the next business day, the agent (bank) needs to purchase Rm100k commodity from the supplier according to the deposit period.

(d) Therefore, the supplier is responsible to provide the RM100k commodity to the bank;

(e) After that, the bank will receive RM100k worth of commodity from the supplier

(f) On the customer’s part, they will receive the notification for ownership of the commodity

(g) Then, customer will sell back the commodity to the bank with a deferred sale price (RM100k + x% profit) according to the maturity date.

(h) Bank therefore purchase (RM100k + x% profit) of commodity. At this level, the bank owns the commodity;

(i) The bank may sell the commodity (RM100k + x% profit) to XYZ company

(j) The XYZ company buys (RM100k + x% profit) commodity from the bank

(k) Therefore, the bank will receive cash money for the commodity transaction from XYZ company

(l) On the maturity date, the bank needs to pay the deferred sale price under sale transaction and customer will receive the amount from agreed sale price (i.e principal + X% profit).

Mudharabah General Investment Account (MGIA)

Commodity Murabah Deposit –i

Contract used Mudharabah Tawaruq, Murabahah & Wakalah

Profit determine Profit Sharing Ratio Mark-up Profit Upfront profit Not Allowed Allowed

Table 1: Comparison between MGIA and CMD-i

Conclusion

Both contracts Mudarabah and Commodity Murabaha provide similar function which help to boost the economic growth and are alternative investment products for the retail segment. But, there are some differences which the customer for commodity


murabahah deposit will enjoy the up-front profit while for the Mudarabah, the customer only gets the profit at the end of investment period. Other than that, the customer or capital provider for the mudarabah account will have two possibilities either profit or loss. But for the commodity murabahah, the customer definitely enjoys the profit as the trading concept of mark-up sale appears between the customer and bank.

Reference Archer, S., Karim, R.A.A (2009).Profit-Sharing investment account in Islamic Bank:

Regulatory problems and possible solutions : Journal of Banking Regulation. 300-309

Alsayyed, N. 2010. The Uses and Misused of Commodity Murabaha: Islamic Economic Perspective. Munich Personal RePEc Archive.2-9.

Bank Negara Malaysia. 2007. Commodity Murabahah Programme. Retrived 19 April 2014, from fromhttp://iimm.bnm.gov.my/index.php?ch=4

Bank Negara Malaysia. 2009. Shariah Parameter Reference 3: Mudarabah Contract

Ismail, A.G., Ghani, W.A.R.N.A., and Zain, M.N.M. Working paper: Tawarruq Time Deposit With Wakalah Principle: An opinion That Triggers New Issues. 1-11.

Dusuki, A.W. 2007. Commodity Murabahah Programme (CMP): An Innovative Approach to Liquidity Management. Journal of Islamic Economics, Banking and Finance.3(1):1-23.

Dusuki, A. W (2010) Islamic Financial System-Principle & Operation. Kuala Lumpur: ISRA Publication

Khan, S.A. Islamic Banking and Finance: Shariah Guidance on Principles and Practices. Percetakan Zafar Sdn. Bhd. Kuala Lumpur.

Rahman, Z. A (2010).Contract and the products of Islamic Banking. Kuala Lumpur: CERT publication.

Rahman, A. Y. Islamic Instruments for managing liquidity. International Journal of Islamic Financial Service.


Country Model: United Kingdom* Islamic Finance started in United Kingdom (UK) with a transaction of Commodity

Murabaha during 1980’s and UK is currently leading the Western world towards growth of Islamic finance. The industry in UK consists of 22 banks including five full-fledged Shariah Complaint banks, a vibrant London Metal Exchange, nine fund managers and seven Shariah compliant exchange-traded funds and 20 law firms offering services in areas related to Islamic finance. In the capital markets, thus far 49 Sukuk have been issued in UK raising US $ 34 billion along with a sovereign sukuk of £2.3 billion. The Government of UK is fully committed to make UK a global destination for Islamic Finance.

The history of Islamic banking in United Kingdom is not very old as it dates back to the launch of Albaraka International Bank, in 1982, though the first Shariah compliant transaction; Commodity Murabaha, took place in 1980. During the decade of eighties many investment banks in UK started offering varied Shariah complaint products particularly for trade finance, leasing and project finance. However, the industry received a real spur with the political and regulatory support at the start of this millennium. The most significant regulatory change was the addition of alternative finance clauses in various taxation acts; the introduction of Finance Act 2003 has removed the double payment of stamp duty land tax on real estate transaction for Islamic finance.

The favourable changes in legal and regulatory environment for Islamic finance started attracting more banks and financial institutions to offer Shariah compliant services; the very first Islamic retail bank; Islamic Bank of Britain, was established in 2004, the first wholesale Islamic Investment bank; European Islamic Investment Bank (EIIB), was set up in 2005 while the British Islamic Insurance Co. also started offering Takaful in 2008.

Sukuk has become the most popular product of Islamic finance in recent years, as London being the centre for issuance and trading of international bonds, became habitat for Sukuk as well. Since the listing of the very first Sukuk on London Stock Exchange (LSE), a total of 49 issues amount US $ 34 billion have been issued. The notable development in this regard is the issuance of first sovereign sukuk of UK government in June of current year (2014); the very first sovereign sukuk of a non-Muslim country of £2.3 billion.

The London Metal Exchange (LME) is a leading metal exchange and is playing the most significant role in extending UK a prominent place on the global landscape of Islamic finance. * Source: State Bank of Pakistan, Quarterly Islamic Banking Bulletin


The distinction feature of UK Islamic finance market is the number of renowned educational institutes offering degrees and trainings related to said industry. University of Durham is the most well known institute offering doctorate program along with summer school. Oxford, Cambridge, School for Oriental and African Studies (SOAS), Reading, Westminster and few others are offering variety of Islamic finance related courses. In addition to these programs various certification courses covering from general Islamic banking to specialized areas are also available; the most significant among these is the Islamic Finance Qualification (IFQ) -the most comprehensive entry level qualification.

Way Forward Given the growth of Islamic finance industry complemented with government’s

commitment to make UK a global destination for Islamic Finance, the future of the industry seems bright in UK. However, the industry would be required to work with government to develop level playing field especially in terms of legislation, regulation and taxation to sustain the growth trajectory of Islamic finance.

Sources • “UK Excellence in Islamic Finance”, UKTI.gov.uk/invest

• https://www.gov.uk/government/news/government-issues-first-islamic-bond{accessed on Sep 8, 2014}

• Global Islamic Finance Report 2014, Edbiz Consulting Limited, Uk

• Global Islamic Finance Report 2010, Edbiz Consulting Limited, Uk


NEWS MONITOR Bahrain to Set up Central Shariah Board for Islamic Banks

December, 2014: Bahrain's central bank is setting up a central sharia board to help oversee Islamic finance products in the kingdom and will introduce new rules to strengthen governance in the sector, central bank governor Rasheed al-Maraj said.

Traditionally, Islamic banks have practiced self regulation to ensure the sharia-compliance of their products, but a centralised model is increasingly being favoured across the global industry. The central bank will introduce new sharia governance rules to expand the internal sharia review and audit functions, while making it mandatory for banks to have an independent external sharia audit. Bahrain's central bank already has a sharia board but its scope is limited to vetting its own products, while a country-level sharia board would help limit product discrepancies, speed the design of new products and boost investor confidence. Source: Reuters

IIFM Publishes Global Standard Documentation on Collateralized Murabahah

November, 2014: The International Islamic Financial Market released its latest master agreement, for an Islamic repo alternative using a collateralized murabahah structure. While not a shift away from a murabahah which has controversially become ubiquitous in interbank transactions, the structure enhances financial stability by providing counterparties with security in the form of sukuk or other Shariah-compliant asset as collateral for the financing.

One area where this could benefit the search for alternatives to murabahah is by lengthening the tenor of interbank financing making it easier to find a product that can generate returns from real economic activity rather than synthetically as is the case with commodity murabahah transactions Source: IIFM Website

India Gets New Islamic Equity Fund November, 2014: India's banking regulators realize the importance of Islamic

Finance in the county; the State Bank of India decides to launch Islamic equity fund to attract the 170 million Muslim population in the country.

The Securities and Exchange Board of India, the country's banking regulator, recently allowed the government-owned State Bank of India and three mutual funds to launch Sharia funds. A large section of India's Muslim population remains outside the banking system, partly because Islamic law known as Sharia prohibits interest. Shares of companies linked to alcohol, tobacco, gambling and casinos and financial institutions that earn interest would be excluded from the fund. Source: Reuters India

Zaman Bank Plans To Become First Retail Islamic Bank In Kazakhstan Kazakhstan's Zaman-Bank JSC will operate in accordance with the principles of

Islamic finance from 2015 according to the announcement made by the Chairman of the Islamic Finance Development Association Mr. Yerlan Baidaulet.


Zaman-Bank plans to become the first Kazakhstani Islamic retail bank and is in the process of getting the required approvals and license. The bank will be offering its services from next year for the retail market. Source: Reuters Meezan Bank Acquires HSBC Pakistan Operations

October, 2014: Meezan Bank, the first and largest Islamic Bank in Pakistan has successfully completed the acquisition of HSBC Pakistan and all branches of HSBC opened with the new purple Meezan look. "It is a historic day for Meezan Bank to have acquired the Pakistan business of one of the world's leading commercial Banks - HSBC", said Irfan Siddiqui, the founding President & CEO of Meezan Bank. He informed Business Recorder that Meezan will benefit from the international best practices and well trained and experienced staffs that are joining Meezan Bank.

The acquisition has added 10 branches and an incremental deposit of Rs 23 billion. Siddiqui said that although these numbers are a very small proportion compared to Meezan's existing size, but our biggest advantage is the quality of financing and trade portfolio of HSBC Pakistan. He expects that Meezan will not only retain all HSBC Pakistan's customers, but further grow the financing book for all these customers as the Balance Sheet of Meezan provides a much bigger platform. Source: Business Recorder Chairman Shariah Board of DIB visits Pakistan

November, 2014: Dr Hussein Hamed Hassan, Chairman of Shariah Board for Dubai Islamic Bank (DIB) the world's first Islamic Bank recently visited Pakistan to meet various Sharia scholars, government dignitaries, senior Islamic bankers, State Bank of Pakistan officials including Saeed Ahmed, Deputy Governor State Bank of Pakistan, prominent Pakistani businessmen and Dubai Islamic Bank Pakistan (DIBPL) management. Dr Hussein during his visit held various crucial meetings on Islamic banking and Shariah-compliance with major stakeholders in the country. Source: Business Recorder Pakistan’s Islamic banking push faces industry gaps -study

Pakistan’s central bank has released a study of Islamic banking, the first of its kind in the country, which shows latent demand for Shariah compliant finance but many obstacles such as small branch networks and a lack of product awareness among consumers. Consumer outreach, rural banking and the need for stand-alone Islamic banks are among issues that must be addressed if the industry is to reach a regulatory target of 15 percent of total banking assets. Source: World news views

State bank launches report on knowledge, Attitude and Practices of Islamic Banking

October, 2014: State Bank of Pakistan (SBP) launched the survey based report “Knowledge, Attitude and Practices of Islamic Banking in Pakistan.” Governor State Bank encouraged the industry to focus on research and development to develop innovative financial solutions that can meet needs of growing clientele of Islamic banking industry. He emphasized that while Islamic banking industry has established its foot prints in international and local market, the industry should not be complacent and stride towards bringing it closer to the key objectives of Islamic economic system; transparency, social justice and equitable distribution of wealth. He formally launched the


KAP report and appreciated the efforts of Islamic Banking Department, and EdBiz Consulting Ltd for successful completion of the project and thanked DFID for financing the study.

Deputy Governor State Bank of Pakistan Saeed Ahmad, in his closing remarks, informed the participants of measures taken by the central bank to address the keys challenges facing the Islamic banking industry. Mentioning the resolve and commitment of the Government of Pakistan for promoting Islamic banking in the country on sound foundations the Deputy Governor shared with the audience progress of the National Steering Committee on Islamic Finance.

Source: The Nation

Representatives of Investment Companies Call on Dar in London November, 2014: Over 25 representatives of international investment companies

called on Finance Minister Muhammad Ishaq Dar in London in the roadshow on Pakistan International Sukuk offering.

Pakistan and additional secretary (external finance) in the meetings with the investment companies, according to a message received here from London. The finance minister, along with his team, briefed the international investors. Most of the investors had invested in the international bond issued earlier this year. The investors were provided with an update on macroeconomic progress made by Pakistan since the roadshows for the Euro Bond in April earlier this year.

Senator Dar also highlighted the improved stable outlook in the country’s ratings since the Euro Bond. He also shared his vision of the roadmap for continued economic prosperity and his government’s efforts to overcome the challenges of economy, energy, extremism, education and health. Ishaq Dar also mentioned the positive sentiments he came across during his recent interactions with the international financial institutions. Investors showed keen interest in the economic performance of the country and the contemplated Sukuk offering, which is likely to be completed shortly.

Source: The News Newspaper

SBP Encourages Research on Islamic Banking Deputy Governor State Bank of Pakistan (SBP) Saeed Ahmed has said that

educational institutes are being encouraged to initiate research on Islamic banking. Speaking at the Lahore Chamber of Commerce and Industry (LCCI), he said the SBP is in regular contact with the Institute of Business Administration Karachi for the establishment of a centre of excellence on Islamic banking. After this, three more such centers would also be established in Lahore, Islamabad and Karachi.

Source: The News Global Islamic banking assets to exceed $3.4trn by 2018, says EY

Global Islamic banking assets with commercial banks are on course to exceed $3.4 trillion by 2018, fuelled by growing economic activity in core Islamic finance markets, according to specialists at Ernst and Young. Its Global Islamic Banking Centre said across the six markets of Qatar, Indonesia, Saudi Arabia, Malaysia, UAE and Turkey (QISMUT), the combined profits of Islamic banks broke the $10 billion mark for the first


time at the end of 2013. If the current growth rate continues, the Islamic banking profit pool across QISMUT markets is set to exceed $25 billion by 2018. Source: Arabian Business

Decrease in Discount Rate Expected In Next Monetary Policy from SBP The State Bank of Pakistan is ready to announce its monetary policy for the next

couple of months; economy experts have predicted a downward trend in discount rate. Currently the discount rate is at 10 percent, the new rate is expected to be announced in few days; a decrease ranging between 50 to 100 basis point is expected, this will help in easing up inflationary pressure from the economy.

The analysts also said that falling international oil prices would also support the widening trade deficit. Expected inflow of $1.1 billion from IMF, disinvestment of OGDCL shares and floating of Ijara Sukuk (Islamic bonds) could also help in easing pressure on rupee, which is currently trading against dollar against Rs 102 mark on inter-bank and kerb markets.

Source: Finance World, Finance and Banking News

Bank of Khyber (Bok) To Expand Islamic Banking Branch Network November 2014: In order to provide Islamic Banking services to the general public

throughout the country, the Bank of Khyber, under a comprehensive plan is in the process to further expand its Islamic Banking Branch Network. The Committee expressed its satisfaction over smooth working of Islamic Banking operations according to the applicable laws of Islamic Shariah and reiterated its stance to take further steps for promotion of Islamic Banking among the masses. The Committee also advised that in formulation of different products and schemes, the Islamic Banking Group must ensure that applicable Islamic laws should not be violated. The Committee further instructed that the Islamic Banking Group must accelerate its efforts to enhance its exposures in different investment avenues so as to generate revenues not only for the institution but its benefits should be trickled down to the general account holders as well.

Source: World News Views

Ishaq Dar reviews progress made by steering committee for Promotion of Islamic Banking

September, 2014: Ishaq Dar promised to provide Islamic banks level play ground to compete with conventional banks. The Finance minister appreciate that the steering committee is working through a number of sub committees on Islamic capital markets, Hedging, and creation of stock exchange Islamic companies index. The committee is to submit its report at the end of the year. Source: Daily Times

HSBC Bank Oman: Meezan to Study Purchase of Pakistani Unit November, 2014: Meezan Bank Limited has received regulatory approval to

study the acquisition of the Pakistani unit of HSBC Bank Oman.

In May, Meezan received central bank approval to buy the local banking business of HSBC, as the European bank exits from countries where it is unprofitable or lacks scale. HSBC Bank Oman is 51% owned by HSBC.


In contrast, Pakistani lenders are expanding, buoyed by a government push to develop the Islamic banking sector in the world’s second-most populous Muslim nation.

The statement did not give a price for the deal, which requires approval from Meezan’s board and final consent by the regulator.

There are five full-fledged Islamic banks in Pakistan as well as 14 Islamic windows, where conventional lenders offer Islamic financial services.

Source: The Express Tribune

INCEIF & CIMB Islamic Set up Research Centre for Banking Studies

The Global University of Islamic Finance and CIMB Islamic Bank have signed a Memorandum of Understanding (MoU) to establish a collaborative framework towards establishing a research centre for Islamic banking studies. Muhammad. Zamree Muhammad Ishak, Chief Operations Officer of INCEIF said, “INCEIF was honored to add another important partner to its growing network of collaborations. CIMB Islamic is a perfect fit to INCEIF as we both share a vision to develop and promote knowledge in Islamic finance. As the only university in the world to focus solely on Islamic finance education and research, INCEIF has become a preferred partner and place of study for many.

Source: INCEIF News Website

Saudi Arabia's Largest Bank, National Commercial Bank, To Convert To Fully Islamic Bank

The largest bank in Saudi Arabia has decided to turn itself into a fully Islamic bank in the next five years after coming in for criticism from the country's Islamic scholars. The state-run bank's decision came amid a $6 billion initial public offer -- the largest ever equity sale in the Arab financial world.

By June, two-thirds of the bank’s assets were Islamic in nature while the remaining was conventional, according to Reuters. The Sharia board has certified that 78 percent of NCB's financing deals, 92 percent of its liabilities and 73 percent of its income, were Sharia-compliant.

Source: International Business Times

Growing role for Japan in Islamic finance: RAM It said while there had yet to be any issuance of J-Sukuk in the Japanese market,

BTMU Malaysia Bhd a wholly-owned subsidiary of Bank of Tokyo-Mitsubishi UFJ, Japan's largest lender – had taken the first important step. In September this year, it became the first Japanese bank to enter the Sukuk market in when it debuted a US$500mil Sukuk programme in Malaysia. More than 150 members from financial institutions, insurance companies, pension funds and corporate from Tokyo. Source: Business News

Islamic Finance Looks to Growth Opportunities in Africa The 3rd Annual Islamic Banking Summit Africa (IBSA Djibouti 2014), which

opened today at the Djibouti Palace Kempinski, saw more than 200 leaders in the


international Islamic banking and finance industry engage in detailed discussions that focused on ‘capturing the Africa opportunity in Islamic finance’. The two day event, held under the official support of the Central Bank of Djibouti, began with an inaugural address by H.E. Ahmed Osman, Governor of the Central Bank of Djibouti. Source: CPI Financial News

Global Islamic Banking Assets to Exceed $3.4trn by 2018, Says EY Global Islamic banking assets with commercial banks are on course to exceed $3.4

trillion by 2018, fuelled by growing economic activity in core Islamic finance markets, according to specialists at Ernst and Young. Its Global Islamic Banking Centre said across the six markets of Qatar, Indonesia, Saudi Arabia, Malaysia, UAE and Turkey (QISMUT), the combined profits of Islamic banks broke the $10 billion mark for the first time at the end of 2013. If the current growth rate continues, the Islamic banking profit pool across QISMUT markets is set to exceed $25 billion by 2018, a statement said. Source: Arabian Business

Dubai Islamic Bank Signs US$230 Million Aircraft Financing Deal with Air Arabia

November 2014: Dubai Islamic Bank (DIB) and Air Arabia announced today the signing of an aircraft financing deal to facilitate the delivery of six new Airbus A320 aircrafts in 2015.The signing ceremony was held in the DIB head office in the presence of senior executives from both parties. The US$230 million Ijara facility will finance the delivery of a new aircraft every two months starting January 2015, the program culminating with the final unit being handed over by the end of the year.

Air Arabia, recently named amongst the Global Growth Companies (GGC) by the World Economic Forum, has seen its route network expand rapidly in 2014 with the addition on new routes such as Cairo in Egypt, Antalya in Turkey, Tbilisi in Georgia, and Samara in Russia. The low-cost airline pioneer now serves 100 destinations from its four hubs in the UAE, Morocco and Egypt. Source: Air Arabia Website

Basel III-Compliant Sukuk, a Catalyst for the Global Sukuk Market Over the past 16 months, since the implementation of Basel III in January 2013, a

total of eight Basel III-compliant Sukuk issuances have been made. Auctioned by seven different issuing banks across Malaysia, Saudi Arabia and the UAE, the deals raised approximately US$4.93 billion. According to KFH Research, the gradual implementation of Basel III accords has led Islamic banks to turn towards Basel III-compliant Sukuk instruments to satisfy the revised capital standards.

Source: Islamic Finance News


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