Interest free transactions of Banks Practice - Free Essay Example

An Islamic bank is a financial institution that conducts its operations base on Shariah principles. Islamic scholars commend trade-oriented banking in place of traditional interest-bearing credit oriented banking. The major vehicle of interest-free banking is a two-tier mudarabah, which is a business contract negotiated on the basis of profit-sharing ratios between two profits-seeking parties, A and B. Parties A provide funds to party B, party B independently manages the business according to the agreed terms. From the banking point of view, it is an advance agreement on a ratio in which realized business profits are to be shared. The basis of two-tier mudarabah is one mudarabah between the surplus economic units (depositors) and financial institution in order to replace interest-bearing contracts between savers and banks; and another mudarabah between the financial institutions and the deficit economic units in order to replace interest-bearing contracts between banks and ultimate users of funds. So, banks can negotiate deposits and advances on the basis of profit-sharing ratios. In effect, interest-bearing loans are replaced by profit-seeking investments and qard hasanah (loans on zero interest). Interest-free financial institution can efficiently perform all types of intermediation after eliminating interest from the system and the replacement of interest rates by profit-shar ing ratios has profound macroeconomic consequences for unemployment, inflation, stability, growth, and income distribution. The Needs of Islamic Banks With Conventional Bank Many Islamic banks use the facilities of conventional banks for treasury management, foreign exchange, portfolio services and investment banking. Major multinational conventional banks have the critical mass to provide specialist service while Islamic banks are usually too small in size to take on such services themselves. Outsourcing makes sense for organizations when the benefits of internalization are outweighed by the administrative costs of trying to extend their functions into new areas where demand is limited. As most Islamic banks are located in the Muslim world, where most of the demand is for core banking services rather than for highly specialized finance, it is a potential management distraction to widen the facilities on offer excessively. This could actually result in deterioration in the quality of the basic level of deposit and funding services. Islamic Bank is Viable Islamic banking and finance are emerging as viable alternatives to conventional interest-based banking and financing. The long-term objective of BNM is to create an Islamic banking system operating on a parallel basis with the conventional banking system. However, similar to any banking system, an Islamic banking system requires three vital elements to qualify as a viable system, such as a large number of players, a broad variety of instruments and an Islamic money market. In addition, an Islamic banking system must also reflect the socio-economic values in Islam, and must be Islamic in both substance and form. Recognizing the above, BNM adopted a step-by-step approach to achieve the above objective. 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. Islamic banking services using their existing infrastructure and branches. The option was seen as the most effective and efficient mode of increasing the number of institutions offering Islamic banking services at the lowest cost and within the shortest time frame. Following from the above, on 4 March 1993 BNM introduced a scheme known as Skim Perbankan Tanpa Faedah (Interest-free Banking Scheme) or SPTF in short. In terms of products and services, there are more than 40 Islamic financial products and services that may be offered by the banks using various Islamic concepts such as Mudharabah, Musyarakah, Murabahah, Bai Bithaman Ajil (Bai Muajjal), Ijarah, Wadiah Yad Dhamanah and Al-Ijarah Thumma al-Bai. Mudarabah (profit-sharing) Refers to an agreement made between a capital provider and another party (entrepreneur), to enable the entrepreneur to carry out business projects, based on a profit sharing basis, of a pre-agreed ratio. In the case of losses, the losses are borne by the provider of the funds. Musyarakah (joint venture) Refers to a partnership or joint venture for a specific business, whereby the distribution of profits will be apportioned according to an agreed ratio. In the event of losses, both parties will share the losses on the basis of their equity participation. Murabahah (cost plus) Refers to the sale of goods at a price, which includes a profit margin as agreed to by both parties. Such sales contract is valid on the condition that the price, other costs and the profit margin of the seller are stated at the time of the agreement of sale. Ijarah (leasing) Refers to an arrangement under which the lessor leases equipment, building or other facility to a client at an agreed rental against a fixed charge, as agreed by both parties. Islamic Banking vs. Conventional Banking There are two major difference between Islamic Banking and Conventional Banking which are conventional banking practices are concerned with elimination of risk where as Islamic banks bear the risk when involve in any transaction and when conventional banks involve in transaction with consumer they do not take the liability only get the benefit from consumer in form of interest whereas Islamic banks bear all the liability when involve in transaction with consumer. Getting out any benefit without bearing its liability is declared illegal in Islam. In retail deposit services include the provision of current accounts and low-risk investment accounts base on mudarabah with clients sharing in any bank profits. Conventional banks provide similar deposit services at retail level and allow overdrafts on current accounts, which often incur both fixed-rate charges and interest. Islamic banks cannot offer overdraft facilities on current accounts. However, depositors who get temporary financ ial difficulties due to events beyond their control such as illness may receive interest-free loans. Conventional banks offer savings rather than investment accounts, the major attraction of such accounts being the interest paid to depositors. This often increases as the minimum notice period for withdrawals lengthens, with accounts which for example require three months notice for withdrawals paying more interest than those requiring one months notice. Some Islamic banks apply similar stepped returns with their investment accounts, with a higher proportionate profit share as the period of notice for withdrawals increases. Moreover, conventional banks focus on money is a product besides medium of exchange and store of value and time value is the basis for charging interest on capital. Islamic banks concern with the real asset is a product but money is just a medium of exchange and profit on exchange of goods services are the basis for earning profit. In conventional banks, Gover nment very easily obtains loans from Central Bank through Money Market Operations without initiating capital development expenditure while Islamic banks, Government cannot obtain loans from the Monetary Agency without making sure the delivery of goods to National Investment fund. Lastly, debts financing in conventional banks gets the advantage of leverage for an enterprise, due to interest expense as deductible item form taxable profits. This causes huge burden of taxes on salaried persons. Thus the saving and disposable income of the people is affected badly. This results decrease in the real gross domestic product. In Islamic banks, sharing profits in case of Mudarabah and sharing in the organization of business venture in case of Musharakah, provides extra tax to Federal Government. This leads to minimize the tax burden over salaried persons. Due to which savings and disposable income of the people is increased, this results the increase in the real gross domestic product. List of Financial Institutions Offering Islamic Banking Services According to the General Council for Islamic Banks and Financial Institutions, there are currently 275 institutions worldwide that follow Islamic banking and financing principles, collectively managing in excess of $200 billion. These institutions are spread throughout 53 countries, including Europe and the United States. Twenty institutions now offer a variety of Islamic financial services in the United States. The Islamic banks are not the only financial institutions involved in Islamic banking. Other financial institutions also offer Islamic banking services through the Islamic Banking Scheme. In Malaysia, separate Islamic legislation and banking regulations exist side-by-side with those for the conventional banking system. The legal basis for the establishment of Islamic banks was the Islamic Banking Act (IBA) which came into effect on 7 April 1983. The IBA provides BNM with powers to supervise and regulate Islamic banks, similar to the case of other licensed banks. The firs t Islamic bank established in the country was Bank Islam Malaysia Berhad (BIMB) which commenced operations on 1 July 1983. In line with its objectives, the banking activities of the bank are based on Syariah principles. After more than a decade in operations, BIMB has proved to be a viable banking institution with its activity expanding rapidly throughout the country with a network of 80 branches and 1,200 employees. The bank was listed on the Main Board of the Kuala Lumpur Stock Exchange on 17 January 1992. After a careful consideration of various factors, BNM decided to allow the existing banking institutions to offer Islamic banking services using their existing infrastructure and branches. The option was seen as the most effective and efficient mode of increasing the number of institutions offering Islamic banking services at the lowest cost and within the shortest time frame. Following from the above, on 4 March 1993 BNM introduced a scheme known as Skim Perbankan Tanpa Faed ah(Interest-free Banking Scheme) or SPTF in short. To link the institutions and the instruments, the Islamic Interbank Money Market (IIMM) was introduced on 4 January 1994. As part of the effort to streamline and harmonize the Syariah interpretations among banks and takaful companies, BNM established the National Syariah Advisory Council on Islamic Banking and Takaful (NSAC) on 1 May 1997 as the highest Syariah authority on Islamic banking and takaful in Malaysia. On 1 October 1999, a second Islamic bank, namely Bank Muamalat Malaysia Berhad (BMMB) commenced operations. The establishment BMMB was the effect of the spin-off following the merger between Bank Bumiputra Malaysia Berhad (BBMB) and Bank of Commerce (Malaysia) Berhad (BOCB). Under the merger arrangement, the Islamic banking assets and liabilities of BBMB, BOCB and BBMB Kewangan Berhad (BBMBK) were transferred to BBMB, while the conventional operations of BBMB, BOCB and BBMBK were transferred to BOCB accordingly. In addi tion, BMMB was given 40 branches of BBMB and BBMBK in various locations throughout Malaysia and a staff workforce of 1,000, migrated from BBMB, BOCB and BBMBK. Islamic Banks 1. Bank Islam Malaysia Berhad 2. Bank Muamalat Malaysia Berhad Participating banks in the Islamic Banking Scheme Commercial Banks 1. AFFIN Bank Berhad 8. Malayan Banking Berhad 2. Alliance Bank Berhad 9. AmBank Berhad 3. OCBC Bank (Malaysia) Berhad 10. Public Bank Berhad 4. Citibank Berhad 11. RHB Bank Berhad 5. EON Bank Berhad 12. Southern Bank Berhad 6. Hong Leong Bank Berhad 13. HSBC Bank (M) Berhad 7. Standard Chartered Bank Malaysia Berhad Finance Companies 1. AFFIN-ACF Finance Berhad 5. Mayban Finance Berhad 2. AmFinance Berhad 6. Public Finance Berhad 3. EON Finance Berhad 7. Southern Finance Berhad 4. Hong Leong Finance Berhad Merchant Banks 1. AFFIN Merchant Bank Berhad 3. Alliance Merchant Berhad 2. Commerce International Merchant Bankers Berhad 4. AmMerchant Bank Berhad Discount Houses 1. Abrar Discounts Berhad 5. KAF Discounts Berhad 2. AFFIN Discount Berhad 6. Malaysia Discount Berhad 3. Amanah Short Deposits Berhad 7. Mayban Discount Berhad 4. CIMB Discount House Berhad