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== DOCUMENT KEY POINTS ==
*islamic banking operations of commercial banks under islamic banking scheme ibs of malaysia the performance analysis by jahongirbek burhonov a thesis submitted in partial fulfillment of the requirement for the degree of master of economics english language program faculty of economics thammasat university october is hereby approved chairman thesis committee assoc
*doctor plearnpit satsanguan date member thesis committee assoc

*the theoretical part of the study concludes by summarizing the problems impeding profit sharing such as the problem of asymmetric information and the costs involved in reducing it the problem of verifying ex ante the promises and intentions that are frequently involved in financial

*transactions adverse selection problem problems of moral hazard incentive problems and the issue of aligning incentives between counterparties agency costs when direct or indirect principal agent relationships arise in financial transactions the need for monitoring behavior of counterparties hence an islamic bank which operates in a competitive market will be concerned about reducing the costs that arise from these incentive problems in order to offer a higher rate of return for attracting depositors particularly if the bank operates side by side with the traditional banks

*the model has been formulated from kabir and bashir study and used to examine the relationship between the performance of malaysian islamic banking scheme ibs conventional banks and the set of internal and external banking characteristics
*after identifying the variables benchmarking islamic banking operations from the performance ratio analysis in what follows we utilized the most important performance indicators in the regression results in chapter

*with a feeling of friendship i must appreciate the unfailing encouragement i used to receive from my friends ramadhan wilaiwan thailand and mainul husain khan bangladesh and from my roommates eisuke kodani japan and yukichika chayama japan which has greatly motivated me to embark on research and complete this thesis
*my appreciation as well goes to my friends at the faculty of economics for their friendship warmth and hospitality especially my seniors p ton p pui p nok p pou p tong my classmates bo kao pick natt ning yasu his memory dewi air nham gift ploy as well as my juniors

*i present this brief work to all who are interested in gaining some knowledge of islamic banking and finance and i humbly ask allah ta ala god almighty to help us benefit from what we learn and to learn that which will benefit us and to protect us from knowledge that is not beneficial and from deeds that are not acceptable to him

*the operations of the standard chartered group in the gulf in the first half of last century are examined by wilson while the general expansion of european banks overseas in the nineteenth and twentieth centuries is studied by born
*as noted by chapra and khan from the very early stage in islamic history muslims were able to establish a financial system without interest for mobilizing resources to finance productive activities and consumer needs

*this was in part because of the political interest it attracted in pakistan in part because of the emergence of young muslim economists but also because the involvement of institutions and governments resulted in the establishment of the first interest free banks

*the islamic development bank idb as an international financial institution established in pursuance of the declaration of intent issued by the conference of finance ministers of muslim countries held in jeddah saudi arabia in december

*furthermore if we include the islamic financial institutions operating in the informal sector in some muslim and non muslim countries the total number of institutions which adhere to islamic principles and could be described as islamic may well be close to

*the operation of the islamic banks is also quite similar to the operation of other joint stock companies in that the shareholders elect a shareholders committee and a board of directors headed by a managing director or chairman who may also be responsible for the day to day functioning of the company
*in terms of ownership structure islamic banks can be classified into international islamic banks publicly owned islamic banks jointventure islamic banks and privately owned islamic banks

*recently several western multinational financial institutions including abn amro american express anz bank of america barclays bnp paribas chase manhattan citibank citi islamic a citicorp s subsidiary commerzbank deutsche bank flemings goldman sachs grindlays hong kong and shanghai banking corporation hsbc jp morgan kleinwort benson lloyds tsb merrill lynch morgan stanley nat west pictet cie royal bank of canada society general standard chartered and ubs among others have also started offering islamic financial products kazarian ray and siddiqi

*data of the study information concerning the operations of islamic banks and conventional banks participating in the islamic banking scheme ibs of malaysia is mainly based on official documents presented in various issues of the concerned bank s annual reports and other publications
*other data sources include international monetary fund s international financial statistics ifs world development indicators global development finance and asian development bank adb statistics and data systems division key indicators www dot adb

*it starts with the outline of the prohibition of interest riba according to the doctrines of islamic economics along with an analysis of the implications which follow from this prohibition for the character of financial intermediation and governance structures in islamic financing
*the former two sections of chapter shed light on profit loss sharing literature to be investigated in the theoretical part while the latter deals with bank performance literature to be investigated in an empirical part

*section starts by analyzing the lack of collateral and rationing of funds and in this context it poses the question what mechanism will an islamic bank use in order to overcome the adverse selection problem put it differently how will an islamic bank discriminate between a high risk project and a low risk project then it addresses an effort incentive problem the need for avoidance of which results in a modified mudaraba contract and finally the subsection on the attitude towards non pecuniary benefits will conclude kazarian analyses
*the second section then discusses funding operations within the islamic financial intermediation concept by summarizing the characteristics of the four main types of accounts current accounts savings accounts investment accounts and special investment accounts

*having illustrated and discussed the islamic banking system in the previous chapters theoretically the aim of the rest of the study is to investigate empirically the performance of islamic banks and conventional banks participating in the islamic banking scheme ibs of malaysia over the period of
*presents financial ratios with regard to six main types of risk credit risk liquidity risk market risk interest profit rate risk earnings risk and solvency risk together with other forms of risk in banking

*the former one analyzes and presents results from the performance ratio methods while the latter one examines and outlines results from the regression methods as described in methodology sections in chapter
*describes the banking characteristics and control variables which ought to be explanatory variables

*these are the absence of interest based riba financial transactions the introduction of a religious levy or almsgiving zakat the prohibition of the production of goods and services which contradict the value pattern of islam haram the avoidance of economic activities involving maysir gambling and gharar speculation or unreasonable uncertainty the provision of takaful islamic insurance and a the establishment of the shari a supervisory board to supervise and advise the bank on the propriety of transactions in line with islamic principles
*islamic financing principles in order to comply with islamic rules and norms five religious features which are well established in the literature must be followed in investment behavior

*riba economic rationale behind the prohibition of interest the prohibition of interest in islam is not based on economic theory but on fundamental religious sources which view the charging of interest as an act of injustice
*the prohibition of riba is mentioned in four different chapters in the holy qur an surah al rum chapter verse surah al nisa chapter verse surah al imran chapter verse surah al baqarah chapter verses

*to the argument that interest is justified as productivity of capital muslim scholars respond that although the marginal productivity of capital may enter as one factor into the determination of the rate of interest interest per se has no necessary relation with capital productivity
*and since hoarding money is injustice it is meaningless to sell money for money except to take money as an end in itself which is injustice ai ghazali

*the reason for its unrealism is that when forced into a position of identifying the pure rate of interest the theorists always refer to the rates of return on riskless assets such as those paid on government securities or the rate of return on debentures of highly successful corporations

*this aspect of the arrangement is crucial since the shari a condemns even a guarantee by the working partner merely to restore the invested capital intact not only because it removes the element of uncertainty needed to legitimize the bargain for possible profits but also because the lender will not be remunerated to the extent of the productivity of his financial capital in the resulting
*there is all the difference between an ordinary shareholder who is one of the proprietors of the enterprise liable for its debts to the extent of his investment receiving a dividend only when a profit is earnedand a creditor who is a debenture holder lending money without the risk of owning and operating capital goods and claiming interest irrespective of the profit or less position of the enterprise

*islam recognizes two types of individual claims to property a the property that is a result of the combination of individuals creative labor and natural resources and b property whose title has been transferred by its owner as a result of exchange remittance of rights to other s in the owners property outright grants by the owner to those in need and finally inheritance
*it is clear that money lent is used either productively in the sense that it creates additional wealth or unproductively in the sense that it does not lead to the creation of incremental wealth by the borrower

*on the other hand when the financial capital of the lender is used in partnership with the creative labor of the entrepreneur the lender s right to his property is not transferred and remains intact thus making him a co owner of the enterprise and his money which represents past productive labor has a claim and a right in the product it helps create
*social justice is the result of organizing society on islamic social and legal precepts including employment of productive labor and equal opportunities such that everyone can use all of their abilities in work and gain just rewards from that work effort

*furthermore as the fulfillment of material needs assures a religious freedom for muslims islamic banks are encouraged to give priority to the production of essential goods which satisfy the needs of the majority of the muslim community

*this prohibition applies in a number of circumstances such as when the seller is not in a position to hand over the goods to the buyer or when the subject matter of the sale is incapable of acquisition for example the sale of fruit which is not yet ripened or fish or birds not yet caught that is short selling

*the majority of jurists are of the view that the sale contract cannot accept clauses of this nature if the sale is shifted to a future date the contract becomes invalida a gharar in a future contract lies in the possible lapse of the interest of either party and to his consent with the contract when the time set therein comes
*thus we can say that gharar infiltrates the a mudhaf contract from the viewpoint of uncertainty over the time that is when the parties conclude the contract they do not know whether they will still be in agreement and have continued interest in that contract when it falls due

*the insurance contract contains maysir gambling due to the participant contributes a small amount of premium in hope to gain a large sum the participant loses the money paid for the premium when the insured event does not occur the company will be in deficit if claims are higher than contributions

*the basic fundamentals underlying the takaful concept are very similar to cooperative and mutual insurance principles to the extent that the cooperative and mutual insurance scheme investing in islamic compliant products is one that is accepted under islamic law
*therefore an islamic insurance transaction would be a policy of mutual cooperation with the elements of shared responsibility and joint indemnity common interest solidarity and brotherhood against unpredicted risk and catastrophe where participants contribute donate to help one another billah

*the latter include the external audit function along with the associated reporting requirements under company law and accounting codes of best practice as well as the actions of shareholders and the role of the stock exchange
*islamic banks employ eminent scholars of islamic law usually on an advisory or consultancy basis in order to ensure that the day to day policies and activities of the bank are in accordance with the shari a

*corporate governance in an islamic bank external regulatory systems internal regulatory systems shareholders board of directors external auditor non executive directors stock exchange audit committee company law internal audit central bank financial regulator shari a supervisory board islamic accounting standards board shari a supervisor judicial adviser internal control systems financial controls compliance with financial reporting operational controls standards shari a compliance audit reviews source lewis and algaoud
*figure

*should the ssb report that the management of the bank has violated the shari a the bank would quickly lose the confidence of the majority of its investors and clients
*first those who deal with an islamic bank require assurance that it is transacting in conformity with islamic law

*preparing the studies and researches required to direct the zakat resources towards the deserving parties and determining the rate or the percentage that in the light of the shari a rules could be invested from the resources of the zakat
*if however the transaction has been executed and later on it is discovered that it has violated shari a the ssb puts its qualified opinion to shareholders and the management makes steps to take out the income generated from that transaction from the income account and have it distributed to a charity account

*specifically the most important features of islamic finance and banking regarding inadequate market discipline asymmetric information incentive structures contractual promises and adverse selection problems principal agent problems moral hazard problems and monitoring decision making under uncertainty mutual cooperation and understanding among conventional and islamic banks legal approach from practical banking angle banking supervision issues the implications of the most salient features of an islamic financial system in particular the absence of fixed interest rates and several country case studies are outlined
*the contemporary literature on profit loss sharing financing in this section a relatively comprehensive review of the contemporary literature on the economics of profit loss sharing modes of financing is provided

*therefore as kazarian argues a mudaraba contract may give rise to a number of incentive problems which can negatively affect the efficient use of funds because a the action of the entrepreneur will affect the return to the bank and b the bank cannot monitor enforce perfectly without high cost the actions of the entrepreneur once the contract has been signed

*kazem sadr and zamir iqbal show the importance of returns to information gathering and monitoring of recipients of funds and entrepreneurs in order to reduce asymmetric information and resultant moral hazard proble miss they provide a useful case study of the agricultural bank of iran abi and show that there are huge benefits for an islamic financial institution investing in supervision and monitoring and in research and development
*they have attributed this to the decrease in the average number of steps and time that the abi takes to conclude a contract a relative increase in the share of musharakah over time and to the composition of outstanding facilities extended to the non public sector by islamic banks

*in such cases entrepreneurs would be honest and reveal actual profit figures to the bank so that the moral hazard problem arising from under reporting of profit would not exist assuming that there is a higher level of trust between islamic banks and their clients than in the case with the conventional banks and hence the moral hazard risks are less
*he discusses the nature of optimal contracts and using the case study of bank muamalat in its mudarabah contracts shows how the proportion of profit sharing financing increased significantly after when the bank introduced its pilot project based on incentive compatible contracts for profitsharing modes of financing

*implications for islamic banking these potentially serious incentive difficulties based by islamic banks and or their depositors in terms of the conventional theory of financial intermediation cast a question mark over whether the system can be made to work
*such incentive evaluation and monitoring is not necessarily a bad thing and it can be argued that if conventional banks had done rather more of it most of the lending disasters of recent decades might have been avoided lewis and davis

*in a conventional interest based system the possibility of bank runs arises from the fact that banks assets can vary in value but their liabilities are fixed in nominal ter miss in an islamic system except for current accounts deposits are profit and loss sharing and any fall in the asset returns of a bank due for example to the impact of economic downturn on the default rate will be matched immediately unless cushioned by reserves built up earlier by a corresponding fall in the profit returns on the bank s liabilities with the value of the investment deposits varying to reflect any losses sustained by the bank
*the fact that islamic banks do not offer directly comparable fixed interest payments to their depositors and undertake risk sharing contracts with borrowers implies that depositors need to take more trouble to choose and monitor the activities of their banks not merely to avoid placing their funds with banks that default but also to obtain the highest return

*initially he assumes that monitoring costs are zero that is both lender and entrepreneur can observe without cost the realized return on a project and that the return is independent of the way the project is financed
*however if borrowers are risk averse which given mutually uncorrelated investment projects is relevant because they are not allowed to diversify across projects then the vrs is superior to frs and full equity is also superior to any combination of debt and equity since equity spreads risk more optimally than debt

*first better monitoring and closer supervision can overcome moral hazard and adverse selection proble miss second stronger supervision provides greater knowledge of the market conditions and environment under which the enterprise subject of the contract has to operate and this allows the supervisors greater ability to forecast further market developments
*additional monitoring and supervision required to reduce information asymmetry come at an additional operating cost which is considered by some to be deadweight cost without creating extra value and thus handicaps islamic banks in competition with conventional banks cobham

*on the one hand the writers contend that an islamic bank will overcome these problems by eliciting the right amount of information when a mudaraba contract is written so that it specifies the appropriate level of the actions of the entrepreneurs
*on the deposit side of the balance sheet there presumably will be many depositors choosing islamic banks on purely ideological grounds and they will not be motivated solely by the returns available

*the empirical part of the study begins in the year in which the first private islamic bank was set up and it examines the performance of two private islamic banks in egypt which have been in operation for a period of ten years by the time study is conducted
*furthermore islamic banks in egypt operate side by side with traditional banks giving an opportunity to compare the performance of islamic banks with that of traditional banks

*after comparing the differences between the two banks in terms of the sources and uses of funds in the financial results in various administrative practices and even in the basic objectives of the banks study presents several performance cases representing the operations of islamic banking in egypt malaysia bangladesh jordan and australia along with sudan iran and pakistan
*as the previous studies on profitability and other measures in the case of malaysian financial institutions ariff mohiuddin sum dirrar samad and hassan used neither statistical technique nor made inter temporal and inter bank comparisons the study by abdus samad and kabir hassan addresses the bank performance in the example of bank islam malaysia berhad in liquidity profitability risk and solvency as well as its commitment to economy and muslim community during

*shahid ebrahim and tan kai joo study the current realities of the islamic banking system of brunei darussalam from the perspective of the theories of modern financial intermediation and islamic financial contracting
*islamic banks can proliferate if they advance towards the second phase by gradually consolidating retail banking with investment banking establish vital links with local and foreign institutions and use ijtihad the act of independent reasoning in order to reach new legal rules in modern financial engineering to optimally design loans while simultaneously reducing their risk exposure

*along this line aziz ponary mlima and lennart hjalmarsson review the literature on banking efficiency and productivity with special emphasis on the measurement of inputs and outputs in the banking industry and conduct an experiment on the sensitivity of efficiency scores based on the choice of variables
*it is inferred from the analysis that such capital adequacy requirements will improve the soundness of current islamic banking practice thus paving the way for the wider use of pls by islamic banks in the long run

*conclusion the four issues a the costs of intermediation the behavior and attitudes of depositors the importance of monitoring costs for contract form and the role of religious precepts in reducing incentive problems a are obviously central to the success of the special islamic modes of finance and these are matters which we can assess empirically in the following chapters when we examine islamic banking in practice

*how do islamic banks or windows perform do they comply partially or fully with the conceptual islamic banking principles if not what are the causes of this phenomenon and which measures could alleviate this trend and bring the islamic banking to its ideals although islamic banking and finance has developed significantly in recent years only very few studies have tackled these central questions
*in particular collateral is embodied in the asset or has to be provided in order to obtain finance while the rates of profit associated with these instruments are largely determined in advance

*is a trust based financing agreement akin to conventional style limited partnership whereby an investor financier rabb al mal or group of investor financiers entrusts capital to an agent entrepreneur mudarib who ploughs this capital into production or trade and then returns to the investor s a prespecified share of his profit

*however if the negligence or mismanagement of the entrepreneur can be proven he may be held responsible for the financial losses incurred

*in the first case the bank participates in the equity and receives a share of the profit on a pro rata basis annually and period of termination of the contract is not specified
*it conforms to the principle of profit and loss sharing and it is suitable for long term project financing hence it is considered to be the purest form of islamic finance

*musharaka entrepreneur b financier a a b a a financier b bank a a b b b financier c provision of capital for a project which all parties may manage profits are shared in pre agreed ratios which need not coincide with the ratio of a financing input b losses are borne in proportion to equity participation source by the author illustrations of islamic financial contracts mainly based on the islamic economics banking and finance literature referred in the bibliography
*however flow charts and figures in these particular forms or shapes presented in this section are of author and mistakes if any thereof are due to him

*they argue that the salient feature of debt as described in the debt literature hart and moore is that it transfers control of an asset to the debt holder in case of default
*these alternative methods which are meant to be applied by islamic banks when the pls principles cannot be utilized include mark up murabaha installments bai bi thaman ajil deferred payment bai muajjal pre paid purchase bai salam manufacturing istisna leasing ijara and lease purchase ijara wal iqtina and beneficence loan qard hasana

*to eliminate the possibility of rejection of goods the customer will generally act as the bank s agent in determining the conformity of the goods prior to acceptance
*the services rendered by the islamic bank are therefore regarded as quite different from those of conventional bank which simply lends money to the client to buy the good

*murabaha promoter supplier negotiates transfers pays bank instructs resells repays at an agreed higher price promoter negotiates the purchase with the supplier promoter instructs the bank regarding goods and services bank buys pays for goods and services as per promoter s instructions transfer of ownership from the supplier to the bank bank resells goods and services to the promoter by installments repayment by the promoter to the bank at an agreed higher price source by the author
*figure

*the islamic institution could either own the plant charge the lessee project company a fee based on profits or sell the plant to the project company on a deferred basis with a profit mark up similar to a murabaha transaction
*it is a contract for production of specified items where a person or a company may ask the bank for production of such items with inputs provided by the maker at an agreed price

*istisna entrepreneur manufacturer delivers produces or repays pays asks provides funding bank asks a pays lease rentals b repays at an agreed higher price entrepreneur asks a bank for production of some items bank provides funding in advance to the manufacturer manufacturer produces goods and delivers to the entrepreneur at a later date ijara case the bank could either own the manufactured items charge the a entrepreneur lessee a fee based on profits
*in this case the entrepreneur lessee pays lease rentals to the bank lessor for a specified period of time with no option of ownership for himself the lessee murabaha case the bank could either sell the manufactured items to the b entrepreneur on a deferred basis with a profit mark up similar to a murabaha transaction

*in this case the bank lessor purchases the asset such as a building piece of equipment or even an entire project and leases it to the clients for an agreed on lease rental together with client agreement to make lease payments installments towards the purchase of the asset from the lessor
*according to islamic jurists the shari a allows a fixed charge relating to tangible assets as opposed to financial assets because by converting financial capital into tangible assets the financier has assumed risks for which compensation is permissible

*the rental equipment is often used in a transient manner whether the situation is one of a rental or a rent the lessor is charged with the responsibility for maintenance
*transactional and intermediation contracts combined with supplementary principles offer a set of instruments with varying purposes maturities and degrees of risk to satisfy a diverse group of economic agents

*abdul awwal sarker and m

*comparative analysis of islamic financing contracts features mudarabah musharakah murabaha istisna a equity financing combining capital equity financing trade financing construction manufacturing le nature of financing and knowledge work partnership based pre financing type of financing trustee profit sharing joint venture profit sharing deferred sale deferred sale le mid term long term short term short to long term mi tenure to years to years except dim

*the first tier mudarabah contract is between the investor and the bank where investors act as suppliers of funds to be invested by the bank on their behalf as mudarib the investors share in the profits earned by the bank s business related to the investors investments
*an islamic financial institution ifi will perform the typical functions of financial intermediation through screening profitable projects and monitoring the performance of projects on behalf of the investors who deposit their funds with the ifi

*according to the two windows model bank liabilities are divided into two windows one for demand deposits liabilities in the strict sense and the other for investment deposits not strictly liabilities the choice of the window being left to the depositors
*it has been argued that in contrast to investment deposits demand deposits are liabilities which are not supposed to absorb any loss and therefore reserve requirement should be introduced for them mirakhor and khan

*however these mentioned different methods can be used in one or the other form not necessarily all methods in one at a time

*one is to accept savings deposits on the al wadiah principle described above but in this case requesting the depositors to grant the bank permission to employ the funds at its own risk while guaranteeing full return of the deposits and sharing any profits voluntarily
*investment accounts the major portion of an ifi s financial liabilities would consist of investment accounts that are strictly not liabilities but a form of equity investment generally based on the principle of mudarabah particularly the case for general investment accounts

*the conditions of this account differ from those of the savings accounts by virtue of a a higher fixed minimum amount b a longer duration of deposits and c most importantly the depositor may lose some of or all of his funds in the event of the bank making losses
*special investment accounts have considerable potential for designing and developing funds with specific riskreturn profiles to offer high net worth and corporate clients opportunities to manage portfolios and to perform risk management

*while the optimal bilateral financial contract depends on a variety of factors a the cost of output verification and or monitoring against moral hazard the presence of adverse selection the degree to which wealth constraints bind the parties involved and the parties attitudes towards risk a there are a large number of circumstances in which debt contracts appear to be optimal

*therefore as kazarian argues a mudaraba contract may give rise to a number of incentive problems which can negatively affect the efficient use of funds because a the action of the entrepreneur will affect the return to the bank and b the bank cannot monitor enforce perfectly without high cost the actions of the entrepreneur once the contract has been signed
*a c finally as the expenditures are borne entirely by the bank this contract provides an incentive to the entrepreneur to expand expenditures beyond the level needed for profit maximization

*in addition to the above mentioned characteristics it is assumed that islamic banks are operating in a non islamic financial environment that is there is fixed salary in the labor market and a fixed rate of interest in the financial market

*in this context what mechanism will an islamic bank use in order to overcome the adverse selection problem put it differently how will an islamic bank discriminate between a high risk project and a low risk project in order to overcome the adverse selection problem the absence of collateral will oblige an islamic bank to ration the supply of funds

*firstly it is assumed that the higher the effort provided by the entrepreneur the higher is the return but at a decreasing marginal rate that is the function y e is strictly increasing continuously differentiable and concave
*as soon as the entrepreneur undersigns the mudaraba contract and gives his predetermined share in the return his problem is to maximize his utility with regard to the level of effort e max y e a ae

*the lower the share of the entrepreneur the steeper the line a the lower is the level of effort and the higher is the inefficiency loss from the project
*this implies that the entrepreneur will maximize his utility by setting his marginal cost of disutility equal to his marginal return and not to the social marginal return

*in other words in order to reduce the incentive problem the compensation to the entrepreneur can be designed as a variable share depending upon the level of effort e where e and not as a predetermined fixed one

*hence a variable share of the return will be accepted by both parties a the bank and the entrepreneur a if it satisfies the pareto criterion that is a higher level of effort will lead to a higher proportion of the return accruing to the entrepreneur and the increase in total return will not belong entirely to the entrepreneur but will also be shared with the bank

*the market value of the outcome from a project is measured on the vertical axis and that of the values of consuming non pecuniary benefits is measured on the horizontal axis
*finally the contract between the bank and the entrepreneur is an exclusive one that is the entrepreneur is not allowed to engage in other activities

*attitude towards non pecuniary benefits outcome y yr i yi c yc ua ya a ub yb b o na nb nr n value of non pecuniary benefits source kazarian if an entrepreneur had dealt with a traditional bank he would borrow a certain amount to be invested in his project and on this sum he would have to pay interest

*thus when the return to the entrepreneur is designed as a proportional share and monitoring his activities by the bank is not possible or prohibitively expensive a mudaraba contract produces incentives to the entrepreneur to consume more non pecuniary benefits than a contract based on a fixed interest
*this means that the welfare of the entrepreneur may improve if he increases consumption of non pecuniary benefits at the cost of a lower return

*after the profit is reported the bank has a right to audit the accounts of the firm at a cost of a
*the conditions under which the bank will fund the entrepreneur on a profitsharing basis and the asymmetric information problems that a bank faces in doing so are discussed next

*this includes the age and size of the firm track record and the length of association of the entrepreneur with the bank on murabahah basis

*the ex post return of the bank will depend on the profit reported by the firm and the decision on auditing of the accounts by the bank
*profit sharing contract to reduce the moral hazard problem the incentive compatible contract discussed in this section has a similar framework to that used by townsend and gale and hellwig to describe debt contracts

*in the profit sharing framework the reward punishment will depend on the actual profit found in the audit ya relative to the reported profit yr by the firm
*i if yr ye audit with the probability of p a ii if yr ye audit with the probability of p iii if yr ye audit with the probability of p a

*the threat of collecting the penalty will be costly if the total penalty f and the invested amount due to the bank l for false reporting are much larger than the payment when true profit is reported
*false reporting the actual profit found in the audit is greater than the reported profit that is ya yr

*the payoffs of the firm will depend on whether the firm reports true false profit and whether the bank decides to audit the accounts of the firm
*if the probability that an audit will be undertaken is p then the expected costs of false and true reporting are given as follows expected cost of true reporting e ct e ct p sya a

*by increasing the weight of the fine the bank can reduce the probability of the firm s under reporting of profit
*first the firm s ex post actual profit ya is greater than the ex ante expected profit ye that is ya ye

*a the actual profit ya is greater than the expected profit ye the firm knows that when the reported profit is equal to the expected profit that is yr ye the probability that the bank will undertake an audit is p p
*this loss by the bank can be classified as the residual loss included in agency costs due to the divergence between the agent s decision and the utility of the principal

*c the actual profit ya is less than the expected profit ye when this is the case the probability of an audit is high that is p a p and the firm will report actual profit
*the step the bank can take to minimize the moral hazard problem is to reduce moral hazard probability p relative to probability of audit p

*bank negara malaysia also issues the malaysian currency the ringgit acts as a banker and economic and financial adviser to the government administers the country s foreign exchange control regulations and acts as lender of last resort to the banking system
*and foreign banks maintain representative offices that do not conduct normal banking business providing only liaison services and facilitating information between business interests in malaysia in their home countries and in countries where they have representations

*merchant banks play a role in the short term money market and capital raising activities including underwriting loans syndication corporate finance and management advisory services arranging for the issue and listing of shares as well as investment portfolio management
*in addition there are institutions comprising building credit companies credit token companies factoring companies and leasing companies that provide credit and financing facilities to the public

*the first step to spread the virtues of islamic banking was to disseminate islamic banking on a nation wide basis with as many players as possible and to be able to reach all malaysians
*however similar to any banking system an islamic banking system requires three vital elements to qualify as a viable system ie a large number of players a broad variety of instruments and an islamic money market

*the same is true in the case of the conventional plus system where the islamic banking institutions operate on the fringe of the domestic banking system and the services they offer are neither as comprehensive nor as sophisticated as the conventional system
*in terms of products and services there are more than islamic financial products and services that may be offered by the banks using various islamic concepts such as mudaraba musharaka murabaha bai bithaman ajil bai muajjal ijara qardul hasana istisna and ijara thumma al bai

*standard chartered bank malaysia berhad finance companies
*list of financial institutions offering islamic banking services in malaysia as of october

*second the islamic banking products in the dual system can also be expected to have a higher level of sophistication compared to the islamic banking products in the single islamic system in other words islamic banks operating in the dual system would have no choice but to create similar sophisticated products on an islamic basis as did the conventional banks
*the overall objective of the master plan for islamic banking and takaful is to create an efficient progressive and comprehensive islamic financial system and to promote malaysia as a regional financial centre for islamic banking and finance

*institutional capacity enhancement involves measures to prepare the islamic banking and takaful industry players to be among the best managed institutions capable of capitalizing on the unique features of islamic banking and takaful to achieve significant competitive edge
*a well developed financial infrastructure as well as an effective legal and shariah framework will enhance malaysia s position to become a leader in islamic banking and finance in the far east region bnm ar ch fs ib section p

*which formulates the model to examine the relationship between the performance of conventional banks participating in islamic banking scheme ibs during and the set of internal and external bank characteristics
*presents financial ratios with regard to six main types of risk credit risk liquidity risk market risk interest profit rate risk earnings risk and solvency risk together with other forms of risk in banking

*each institution s stock price is a function of a expected stream of future stockholder dividends e d t value of the bank s stock p discount factor a r t t based on the minimum required market rate of return on equity capital given each bank s perceived level of risk where e dt represents stockholder dividends expected to be paid in future periods discounted by a minimum acceptable rate of return r tied to the bank s perceived level of risk

*the banking organization s perceived level of risk has fallen due perhaps to an increase in the bank s capital reserves a decrease in its loan losses or the perception of investors that the bank is less risky overall perhaps because it has further diversified its service offerings and expanded the number of markets it serves and therefore has a lower equity risk premium
*performance ratios while the behavior of a stock price is in theory the best indicator of a business firm s performance because it reflects the market s evaluation of the firm s performance this indicator is often not reliable in banking rose

*the following sections present the most important measures of a bank s performance which are asset management ratios profitability ratios and expense ratios as well as ratios with regard to six main types of risk credit risk liquidity risk market risk interest rate risk earnings risk and solvency risk together with other forms of risk in banking hassan samad and hassan mishkin rose kabir and bashir and mikdashi

*it approximates the net benefit that the stockholders have received from investing their capital in the bank ie placing their funds at risk in the hope of earning a suitable profit
*net bank operating margin total operating revenues a total operating expenses total assets

*therefore these two profit indicators can be linked directly rose total assets roe roa or total equity capital net income after taxes net income after taxes total assets total equity capital total assets total equity capital but we note that the bank s net income is equal to its total revenues minus its operating expenses and taxes
*useful profitability formulas in analyzing how well any given bank is performing it is often useful to break down some of these profitability ratios into their key components

*net income after taxes the bank s net profit margin npm total operating revenues total operating revenues the bank s degree of asset utilization au total assets total assets the bank s equity multiplier em total equity capital accounts each component of the equation is a significant indicator of a different aspect of the bank s operations figure

*a slight variation of this roe model produces an efficiency equation useful for diagnosing problems in four different areas of bank management net income after taxes roe net income before taxes and securities gains or losses net income before taxes and securities gains or losses total operating revenue total operating revenue total assets total assets total equity capital accounts or tax expense asset funds roe management control management management efficiency efficiency efficiency efficiency
*the multiplier is a direct measure of the bank s degree of financial leverage a how many dollars of assets must be supported by each dollar of equity owners capital and how much of the bank s resources therefore must rest on debt

*in this case we have merely split the bank s profit margin into two parts a tax management efficiency ratio reflecting the bank s use of security gains or losses and other tax management tools such as tax exempt bonds to minimize its tax exposure and the ratio of before tax income to total revenue as an indicator of how many dollars of revenue survive after operating expenses are removed a a measure of operating efficiency and expense control
*total operating expenses operating efficiency ratio total operating revenues net operating income employee productivity ratio number of full time equivalent employees detailed analysis of bank profitability measures with regard to their respective components informs us much about the causes of bank earnings difficulties and suggests where management needs to look for possible cures for any earnings problems that emerge

*because banks hold little owners capital relative to the aggregate value of their assets only a relatively small percentage of total loans is enough to turn to bad to push any bank to the brink of failure

*the final two credit risk indicator ratios reveal the extent to which a bank is preparing for loan losses by building up its loan loss reserves the allowance for loan losses through annual charges against current income the provision for loan losses

*cash assets include vault cash held on bank premises deposits the bank holds at the central bank in its district deposits held with other banks to compensate them for clearing checks and other interbank services and cash items in the process of collection mainly uncollected checks

*changes in market interest rates and currency prices shifting public demands for bank services relative to the services offered by non bank firms sudden alterations in central bank monetary policies and changing investor perceptions of the riskiness of banks cause the value of bank assets liabilities and equity to move up or down frequently depending on the direction of financial changes
*market risk in market oriented economies where most of the world s banks offer their services today the market values of bank assets liabilities and net worth are constantly in a state of influx creating market risk

*types of instruments in islamic interbank money market iimm a mudarabah interbank investment mii b wadiah interbank acceptance c government investment issue gii d bank negara negotiable notes bnnn e sell and buy back agreement sbba f cagamas mudarabah bonds smc g when issue wi h islamic accepted bills iab i islamic negotiable instruments ini j islamic private debt securities k al rahn agreement i ra i interest rate risk manifests itself in several ways

*thus a bank s stockholders always face the possibility of a decline in their earnings per share of stock which would cause the value of the bank s stock to fall eroding its resources for future growth

*the ratio of equity capital net worth to total assets held by the bank where a decline in equity funding relative to assets may indicate increased risk exposure for the bank s shareholders and debt holders
*if the bank takes on an excessive number of bad loans or if a large portion of its security portfolio declines in market value generating serious capital losses when sold then its capital account which is designed to absorb such losses may be overwhelmed

*banks of all sizes and forms also face several other important types of risk bacha inflation risk a the probability that an increasing price level for goods and services inflation will unexpectedly erode the purchasing power of bank earnings and the return to shareholders
*capital adequacy ca captures bank safety and a higher capital adequacy ratio results in a bank to be exposed to lower financial risk which in turn provides the possibility of attracting more purchased funds at a lower cost

*the subsequent regression analysis starts from estimating the following basic equation i it a ai bit t m t t ft it where i it is the measure of performance either roa roe rod nim or npm for bank i at time t bit are bank variables for bank i at time t m t are country macro variables at time t and ft are the financial structure variables at time t

*it is a common practice for the parent bank to grant ibs banks a seed capital but still allow it ie ibd to use the existing mainstream banking overheads such as branch office premises and computer and security syste miss in this way the ibs bank may have benefited from the parent s capital base and thus is expected and is able to report bigger roe in view of the relatively smaller capital base it holds

*we expect that earnings will not differ in a dramatic way from loans in view of the vast similarities observed in the two syste miss net investment margin nim is the difference between total income from earning assets and income attributable to depositors divided by total earning assets

*the set of ratios used comprises measure of earnings efficiency es fund source management cstfta funds use management ohta and nii measure of employee productivity in the bank operations epr leverage and liquidity ratios cap and tlafta and finally the measure of the amount of total loans which are doubtful nnpltlaf
*if other factors are held constant the bank s spread will decline as competition increases forcing management to try to find other ways generating fee income from new services to make up for an eroding earnings spread

*however since most of the islamic banks loans and financing are on the form of profit and loss sharing loans with equity features the loan performance relationship depends significantly on the expected change of the economy
*this supports the view that profitable banks remain well capitalized or the view that well capitalized banks enjoy access to cheaper less risky sources of funds with subsequent improvement in profit rates see bourke

*however as noted earlier since most of the islamic banks loans and financing are in the form of profit and loss sharing loans with equity features the loan performance relationship depends significantly on the expected change of the economy
*net non performing loans non performing loans after specific provision and income in suspense over total loans advances and financing nnpltlaf ratio is the measure of the amount of total loans which are doubtful

*in this study we use the ratio of total bank deposits to gdp depgdp to measure the influence of the financial and capital market
*yet real interest rate may have a negative effect on bank profitability if higher real interest rates lower the demand for loan

*evaluating the performance of small and large ibs banks in this section the performance of small and large ibs banks are presented and then compared with the industry average of ibs banks over
*large banks have total assets range between x in rm whereas small banks have total assets range between x in rm where x stands for total assets

*standard chartered bank malaysia berhad ns ns notes during the financial half year ended june the group and the bank have adopted the revised guidelines on financial reporting institutions bnm gp issued by bank negara malaysia which became effective for the current financial year
*data availability of islamic banks and commercial banks participating in ibs of malaysia year of available data type of bank name of bank incorporation detailed data span of time to study quarterly data

*citibank total rm average rm notes large banks total assets range is between x in rm small banks total assets range is between x in rm the group and the bank as the financial position of the bank is not materially different from the group the amounts are not separated respectively
*segmentation of commercial banks participating in ibs of malaysia name of banks total assets name of banks total assets large banks small banks

*in summary we can state that although the average values of the asset management efficiency ame ratios of both banks show absolute resemblance to that of industry average the expense control efficiency ece of small banks was higher than that of large banks and industry average but in contrary the tax management efficiency tme and funds management efficiency fme ratios of the large banks were higher than those of the small banks and industry average
*tax expense asset funds roe management control management management efficiency efficiency efficiency efficiency in this case we have merely split the bank s profit margin into two parts a tax management efficiency ratio reflecting the bank s use of security gains or losses and other tax management tools such as tax exempt bonds to minimize its tax exposure and the ratio of before tax income to total revenue as an indicator of how many dollars of revenue survive after operating expenses are removed a a measure of operating efficiency and expense control

*in contrary the employee productivity ratio epr and total assets to number of full time employees ratio ta nume of the large banks was on the average higher than those of the small banks and industry average
*the recent banking crises suggest that in many cases liquidity crises have their roots in solvency proble miss it is therefore extremely important to monitor liquidity indicators because poor management of short term liquidity may force solvent banks toward closure

*however the average value of the tax management efficiency tme of bimb was much lower than those of bmmb and industry average indicating worse tax management efficiency and the average value of the asset management efficiency ame of bimb shows close resemblance to those of bmmb and industry average indicating similar asset management efficiency
*and it should be noted that although bmmb had quite supportive positive tme ame and fme ratios the negative expense control efficiency ece ratio resulted in negative roe for bmmb

*risk ratios section liquidity risk and solvency risk subsection the average values of the customer and short term funds over total assets cstf ta and total loans advances and financing over total assets tlaf ta investment securities over total assets is ta temporary investments ratio tir and volatile liability dependency ratio vldr ratios for bmmb and industry average

*although both types of banks on the average maintain the basle committee s uniform standard of capital adequacy of percent banks represented in industry average tend to maintain much higher capital asset ratios than bmmb and bimb
*although these components indicate that the liquidity base of bmmb is quite strong the deliberate concern should be given to the fund mobilization and its allocation to prevent liquidity divergence

*the performance of islamic banks bank muamalat malaysia berhad bmmb and bank islam malaysia berhad bimb are presented and then compared with the industry average of ibs banks over the period of
*we may conclude that bank islam malaysia berhad bimb is comparatively effective in assets quality profitability operations liquidity and capital adequacy aspects of assessing bank performance whereas bank muamalat malaysia berhad bmmb seemed to have some merit in assets quality

*the regression analysis starts from estimating the following basic equation i it a ai bit t m t t ft it where i it is the measure of performance either roa roe rod nim or npm for bank i at time t bit are bank variables for bank i at time t m t are country macro variables at time t and ft are the financial structure variables at time t
*the model has been formulated from kabir and bashir study and used to examine the relationship between the performance of malaysian islamic banking scheme ibs banks and the set of internal and external banking characteristics

*although the primary focus of this study is the relationship between the performance and bank internal variables the inclusion of macroeconomic variables and financial structure variables is meant to control for cyclical factors that might affect bank performance

*however as noted earlier since most of the islamic banks loans and financing are in the form of profit and loss sharing loans with equity features the loan performance relationship depends significantly on the expected change of the economy
*this supports the view that profitable banks remain well capitalized or the view that well capitalized banks enjoy access to cheaper less risky sources of funds with subsequent improvement in profit rates see bourke

*although the ratio of consumer and short term funding to total assets cstfta had significant negative coefficient in benchmark regression of return on assets roa the introduction of control variables resulted in insignificant positive relationship in specification between roa and cstfta variables
*employee productivity ratio epr is directly significantly and positively related to return on assets roa return on equity roe and net profit margin npm but it has no effect on net investment margin nim

*net non performing loans over total loans advances and financing nnpltlaf is directly significantly and positively related to return on assets roa and net investment margin nim but it is not statistically significant in return on deposits rod and net profit margin npm
*perhaps these results occurred mostly due to the loan restructure policies such as lowering lending rate income profit rate or prolonging maturity of the loans for the defaulting borrowers which in turn resulted more loans to be rehabilitated from nearly chargeoffs into written backs

*the impact of the taxation variable the required reserve of the banking system res on the performance measures is significantly and positively correlated with the return on equity roe only indicating that high required reserves increase the returns on equity of ibs banks
*finally financial structure variable the ratio of total bank deposits to gdp depgdp has demonstrated significant and positive relationship with return on assets roa return on deposits rod and net profit margin npm indicating that high total bank deposit level with regards to gdp increases return on assets roa return on deposits rod and net profit margin npm of ibs banks

*the second is an empirical part and addresses the second objective of the study to evaluate empirically inter temporal and inter bank performance in assets quality profitability operations liquidity and capital adequacy of the malaysian islamic banks and commercial banks under islamic banking scheme ibs during with the application of islamic banking principles
*the reason for choosing malaysia as a sample of the study is as follows the introduction of the interest free banking scheme skim perbankan tanpa faedah in malaysia on march th was premised on a dual banking system a full fledged islamic banking system operating on a parallel basis with a sophisticated conventional banking system

*these problems can be summarized as follows the problem of asymmetric information and the costs involved in reducing it the problem of verifying ex ante the promises and intentions that are frequently involved in financial transactions adverse selection problem problems of moral hazard incentive problems and the issue of aligning incentives between counterparties agency costs when direct or indirect principal agent relationships arise in financial transactions the need for monitoring behavior of counterparties

*the performance of islamic banks bank muamalat malaysia berhad bmmb and bank islam malaysia berhad bimb are presented and then compared with the industry average of ibs banks over the period of

*one of the main points of islamic banking at least in theory is that unlike conventional banking it is concerned about the viability of the project and the profitability of the operation but not the size of the collateral
*we may conclude that bank islam malaysia berhad bimb is comparatively effective in assets quality profitability operations liquidity and capital adequacy aspects of assessing bank performance whereas bank muamalat malaysia berhad bmmb seemed to have some merit in assets quality

*part of the explanation is that the small incremental return between the shorter and longer placement tenures and the uncertainty of future rates of return led to the continued concentration at the shorter end of the yield curve by depositors

*time has also come to broaden the scope and further explore structuring musharakah partnership and mudarabah profit and loss sharing contracts to address the capital injection financing requirement and packaging it together with the earlier contracts of exchange thus providing the working capital in delivering productive assets and commodities into the market

*saudi arabia albaraka islamic bank bahrain albaraka islamic investment bank bahrain dar al mal al islami trust geneva faisal islamic bank guinea faisal islamic bank niger faisal islamic bank senegal faysal investment bank of bahrain islamic investment co
*london bangladesh islamic bank bank al tamwil al saudi al tunisi bank islam malaysia berhad kuala lumpur banque islamique de guinee banque islamique du niger banque islamique du senegal beit elmal saving and investment co

*adil islamic growth fund labuan malaysia al meezan commodity fund ies dublin citi islamic investment bank bahrain faisal finance jersey first islamic investment bank bahrain ibn khaldoun international equity fund virgin islands tadhamon islamic bank yemen yemen islamic bank for finance and investment
*albaraka finance house india al jazeera investment company doha qatar anz global islamic finance london banque albaraka djbouti muslim community cooperative mcca melbourne turkishkuwaiti finance house istanbul turkish kuwaiti finance house qatar

*bank ifi syariah unit bank syariah mandiri indonesia habib nigeria bank islamic windows nigeria bank bumi muamalat malaysia bhd malaysia gulf finance house bahrain bank for agriculture and agricultural cooperatives islamic branches thailand
*set up during the name of islamic institution year al manzil islamic financial services new york badr bank moscow islamic bank of brunei berhad brunei islamic international arab bank jordan

*on the assets side the contract between the bank and the agententrepreneur is known as a restricted mudarabah because the bank agrees to finance a specific project carried out by a specific agent entrepreneur and to share the relative profits according to a certain percentage
*appendix ii table islamic financing contracts profile intermediation contracts trustee finance type description comments pls profit and loss sharing modes at the core of islamic banking modes mudaratrustee finance contract ba muqathe bank provides the entire capital needed three conditions need to be met rada for financing a project while the trustee entrepreneur offers his labor and expertise

*appendix ii profile transactional contracts equity participation type description comments pls profit and loss sharing modes at the core of islamic banking modes mushara a partnership arrangement between two musharaka company or kah parties or more to finance a business project partnership contract is a form of equity whereby all parties contribute capital either business organization where two or participa in the form of cash or in kind for the more persons contribute to the tion purpose of financing the business project
*muzara a crop sharing a contract whereby one party crop it is a contract between an owner of a agrees to till plow cultivate the sharing piece of agricultural land and a farmer for land owned by the other party in farming it in return of a percentage of its consideration for an agreed share in crop

*appendix ii profile transactional contracts asset based securities trade financing type description comments non pls non profit and loss sharing modes at the core of islamic banking modes murabaha an agreement that refers to the sale and this is a cost plus contract in which marka up purchase transaction for the financing of an one party wishing to purchase financing asset or project whereby the costs and profit equipment or goods and margin mark up are made known and commodities approaches other agreed by all parties involved

*appendix ii profile transactional contracts asset based securities collateralized securities type description comments non pls non profit and loss sharing modes at the core of islamic banking modes ijarah leasing in fact banks add a certain leasing a manfaah usufruct type of agreement percentage to the purchase price whereby the lessor owner leases out an and or additional costs associated asset or equipment to its client at an agreed with these transactions as a profit rental fee and predetermined lease period margin and the purchased assets upon the aqad contract

*appendix ii profile transactional contracts miscellaneous type description comments non pls non profit and loss sharing modes at the core of islamic banking modes qard albeneficence loans as part of their mission islamic hasanah a contract of loan between two parties on financial institutions are benethe basis of social welfare or to fulfill a encouraged to make charitable ficence short term financial need of the borrower

*dhaman a contract of guarantee provided by a in the case of kifala a third party kifala or person to the owner of an asset who has becomes surety for the payment of kafalah placed or deposited his asset with a third a debt if unpaid by the person party whereby any subsequent claim by the originally liable
*non profit and loss sharing modes at the core of islamic banking concepts amanah amanah and qard hasan deposits are deposits held at the bank for demand conventional deposit and transfer accounts safekeeping purpose

*ittifaq a sale and repurchase of the underlying dhimni asset of which the prices are agreed by the parties prior to the completion of the contract
*non profit and loss sharing modes at the core of islamic banking concepts ibra an act by a person to withdraw his rights ie his rights to collect payment from a person who has the obligation to repay the amount borrowed from him

*same contract the power to nominate another wakalah can also be used to give a power of attorney person to act on his behalf as long agency to someone to represent another s interests

*table cont

*appendix ii card services products services applicable concepts charge card i qard credit card i bai inah bai bithaman ajil debit card i ujr banking services products services applicable concepts stockbroking services ujr tt funds transfer ujr travellers cheques ujr cashiers order ujr demand draft ujr standing instruction ujr atm service ujr telebanking ujr source http www dot bnm
*table cont

*kazem sadr and zamir iqbal a choice between debt and equity contracts and asymmetrical information some empirical evidence in a islamic banking and finance new perspectives on profita sharing and risk in munawar iqbal and david t


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== DOCUMENT WORD ANALYSIS ==
=== Main Category ===
: AlHuda Material\islamic banking


=== KeyWords ===
islamic banks banking financial finance investment conventional institutions funds risk financing deposits assets services management international countries equity profit products



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== DOCUMENT REFERENCES ==


=== Number of Pages ===
244


=== Published Date ===
2006-11-05 18:38:39


== Full Document ==


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[[Category:Islamic Finance]]

[[Category: Islamic Banking]]