Islamic banking by conventional interest-based banks
Saturday, 9 October 2010
Islamic banking is a system of banking that avoids receipt and payment of interest in its transactions and conducts its operations in accordance with Shariah principles to achieve the objectives of Islamic economy. Growth of Islamic banking over the last decade in general and after the recent global financial crisis in particular has been tremendous. Bangladesh is also not lagging too behind in this respect. Besides growth, there have been some dimensional developments in the field of Islamic banking in Bangladesh. Apart from first generation established Islamic banks, which have been operating under Islamic Shariah, most of the leading conventional banks have opened Islamic banking windows to deliver service according to Shariah principles. This trend indicates that Islamic banking will keep flourishing and increase its share in the banking industry of the country. In spite of the vigorous growth, many bankers are yet to be familiar with the process by which Islamic banking can be conducted side by side the conventional system. Some people may be interested to know this dual system of banking. As fundamentals the following areas or phases are imperative to ensure successful introduction of Islamic banking into a conventional system:
Honest Commitment of the authority: The authority of the bank concerned should be honestly convinced of the concept of Islamic banking and committed to it. Only committed management of a bank with honest support of Board of Directors can ensure complete compliance and commitment to Islamic banking. Again Shariah people are not usually available in all the phase of the banking operations. Authorities of the bank would hire the right human resources only when they are convinced and committed. If the target of Islamic banking merely covers expansion of business of the bank with a Shariah-signboard to attract a specific target group by any means without any honest commitment, it may jeopardise its aims and objectives. A fair policy of the committed management can ensure right direction for Islamic banking operations. Even a bank does at all not necessarily need to put the word 'Islamic' in its signboard. It is rather the belief, mission and action that will say whether it is truly Islamic or not. So, commitment of the authority plays a vital role in introducing Islamic banking operations in a conventional bank.
Recruitment and continuous development of competent human resources:
Human resources are important to implement any policy. It is, therefore, men behind the machine are actually responsible for production. So, selection of the right team in respect of competence, honesty, integrity as well as willingness to establish the ideology of Islamic banking will be the next vital step. Principle is to dominate over practice by the competent right bankers /operators. Appropriate personnel will thus be one of the key factors for introduction of Islamic banking particularly when operated in a conventional Bank.
Shariah compliance: Apart from recruitment of professional bankers, a bank wishing to offer Islamic products must appoint knowledgeable personnel to ensure shariah compliance in its Islamic banking operations. In this regard according to the recent Islamic Banking Guidelines of Bangladesh Bank, a bank may appoint a Shariah Supervisory Committee comprising, among others, qualified Islamic scholars. Shariah Scholars may be included in the Board of Directors of the bank, who is responsible to ensure Shariah compliance in their Islamic banking operations. This initial step is essential for the future of the bank, as it will help full compliance of Shariah.
Segregation of Islamic banking fund from conventional fund:
Operationally, the most important principle behind Islamic finance is the desire to maintain the moral purity of all transactions. The funds intended for Shariah-compatible investments should therefore not be mixed with those of non-Islamic ones. This requirement is, however, not based on the assumption that all the activities of a conventional bank or those of non-Muslims are intrinsically impure. The rationale behind this principle is rather one of prudence, in the sense of taking all the necessary precautions to ensure that Islamic funds are not mixed with other funds that may get involved in interest, or haram activities or close to them.
Therefore, in order to ensure compliance with Islamic principles, conventional banks wishing to offer Islamic products must guarantee and publicise that the funds devoted to conventional activities will not be mixed with those reserved for Islamic activities. In operational terms, this requires that banks establish different accounts, and reporting systems for each type of activity. In this case, when a conventional bank opens an Islamic unit it is, to a large extent, a separate entity from the rest of the bank. It is a bank within a bank. As such to run Islamic banking in parallel with conventional banking in a systematic way, there must be an Islamic Fund Manager maintaining separate general/settlement account for Islamic banking operations distinct from the conventional inter branch General A/c. Any transaction between an Islamic banking unit and a conventional unit shall be treated as Inter-bank (not inter-branch) transaction and be reconciled by the respective fund managers at the head office level. For reconciliation purpose they may create counter/corresponding settlement (Islamic Settlement in conventional unit and Conventional Settlement in Islamic unit) A/C.
Any transaction between the fund managers of conventional banking and Islamic banking at head office level shall also touch the corresponding Settlement A/Cs. Only transaction/s between two Islamic units shall be treated as inter-branch one and be titled as BIG (Bank's Islamic General) A/C. Finally it is the balance of Settlement A/C which would indicate whether Conventional or Islamic is the surplus unit for the day concerned.
Then the Balance of Settlement A/c may be treated as under: If the net balance of Settlement A/C for any month is in favour of conventional unit (Credit balance / borrowed from conventional) the same may be treated as if it were the deposit of conventional Bank kept in any Islamic Mudaraba Account with the Islamic Banking units. As in a Mudaraba Account, profit is shared according to predetermined Income Sharing Ratio (ISR) between the Bank and the client, profit to the conventional unit shall be paid on that amount at the rate attained as per ISR for that period by the concerned Mudaraba A/C holders as usual. Here the terms and conditions of operating Mudaraba A/cs as stipulated by the Islamic banking would be binding upon the conventional unit. Here the treatment is, as if conventional unit is one of many other depositors of Islamic Banking who open account therewith being fully agreed upon with the prescribed Shariah & other related terms and conditions. Rationale for the proposition is that Islamic Banks in general do not restrain any individual or institute from opening any Mudaraba (or any other usual) A/C with the Bank on the plea of the depositor's religious belief or obedience per se. So, if found otherwise ok, a Non-Muslim or any conventional Bank or institute can open/ maintain Mudaraba A/C with any Islamic Bank. Accordingly any such depositor has got every right to enjoy due share of Mudaraba profit from the Islamic Bank as long as he/it abides by the concerned Mudaraba A/C rules.
It would be very relevant to quote here from Shari'a Standards published (1425-26 H) by the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI, a Bahrain based institution established in 1990-1991) which issues internationally recognized Shariah standard on accounting auditing and governance issues. Under certain discipline it has also been opined to be permissible to run partnership business with non-Muslim or conventional banks. The spirit and reality must be practically reconciled with fair intention to keep the wheel of economy running rather than to stop it. "It is permissible for the institution to enter into a partnership contract with non-Muslims or conventional banks to carry out operations acceptable by Shari'a unless it has become evident that the funds or items presented by these entities for the purpose of the partnership are from non-permissible sources. In operating a partnership with non-Muslims or conventional banks, arrangements must be made to obtain all necessary assurances and guarantees that rules and principles of the Shari'a are observed during operations of the partnership. Among such guarantees is one to the effect that the operations of the company be either managed or supervised by an entity that observes the Shari'a rules Unquote (page 201). So it is rather better that bank or Islamic Bank itself becomes the Mudarib for onward fair utilization of the fund for maintaining sanctity."
If the net balance of the Settlement A/C is in favour of the Islamic unit (Debit balance/ lending to conventional unit) for any month, the sum of the daily product of the balance (instead of any profit amount) shall be carried over to the following month/s until complete set off by the corresponding credit balance of the product (sum of the daily product). But no such carry over of the sum of the product shall be made beyond the Annual closing. In case any debit balance remains on the eve of yearly closing the said product shall be nullified/ ignored henceforth without any return from the conventional side i.e. unavoidable use of Islamic Banking fund by the conventional unit is to be treated as Quard (certainly bearing no return thereon). Rationale for this proposition is to accept minimum level of gharar (uncertainty / deception) to refrain from haram (interest). To avoid such circumstances even, any surplus fund of Islamic Banking shall rather be duly placed to any Shariah based Bank or NBFI by the Islamic Fund Manager.
For fund transactions between two Islamic units no real profit shall be paid /received. But with a view to evaluating the individual performance of any specific Islamic unit, customary nominal rate of profit may be applied on Bank's Islamic General or BIG A/C. But in this case no differential rate would be applied for deficit and the surplus unit. This measure would ensure ultimate net balance arising from the same corresponding amount of such A/C nullifies each other.
By their very nature, Banks combine in their balance sheets short-term liabilities with long-term assets, resulting in maturity mismatches. Banks try to minimize the potential risks resulting from these mismatches by actively managing their liquidity needs, typically through inter-bank money markets. Given that conventional inter-bank markets are interest-based markets, Islamic banks cannot participate there to manage their liquidity positions, and therefore an alternative market design is required. One thing is to be made clear in this regard that segregation, rather management of fund in an Islamic Unit of Conventional Bank, is extremely important and of course, one of the most difficult as well as questionable issues. An Islamic Inter-bank Money Market is, therefore, of dire need.
Owing to absence of Islamic Inter-Bank Money Market, Islamic banks in conventional systems have, for years, operated with no access to tradable short-term treasury instruments through which excess funds can be channelled to other Islamic banks. This has restricted their growth potential by forcing them to hold substantial cash reserves. A suggestion of Bangladesh Bank to open Mudaraba SND A/c with each other of the Islamic banking operators may pave the way for development of an Islamic Inter Bank Money Market.
Compliance of Accounting & Auditing Standard: Following a standard brings uniformity in an industry allowing a level playing field for interpretation of respective position of all the participants/ units. As such a separate chart of Accounts (Conforming to a uniform Islamic Standard) is a must for Islamic banking in conventional banks. The need for a body of accounting standards purposefully designed to reflect the specialisation of Islamic products is a crying need for Islamic banking as new and more complex instruments are being marketed now-a-days.
Awareness Campaign: The speed and extent of success with which Islamic banking to emerge in conventional systems largely depend on whether potential clients are well informed about the opportunities and risks, and on whether Islamic banking is perceived as a transparent and well-regulated activity. Moreover, the doubt about practicability of Shariah compliance in the dual system will have to be removed through confident and intelligent arguments. This awareness campaign would also ensure compliance with Pillar-3 of BASEL-II. This pillar encourages banks to have market discipline/public disclosures such as to publicly provide details of relevant information vis-à-vis the amount & means of management of risk ensuring better transparency and confidence of the stakeholders.
Presentation of separate as well as consolidated statement of affairs: An independent, complete and separate books of accounts reflecting periodical activities and results along with a 'true and fair state of affairs' of Islamic banking units as a whole is to be had having a full chart of Accounts. Annual Report of the bank must integrate the full scenario of its Islamic as well as the conventional banking operations.
Controversy over sanctity of operating Islamic Banking in Conventional Banks: Although the phenomenon of Islamic banking operation in interest based banks has by this time got a momentum of its growing trend in the banking circle, disputes still remain whether the two types of transactions can be operated with their distinct spirit or if such arrangement is acceptable from Shariah point of view and so on. In this digital era, we must believe that it is technically feasible to keep the two different types of transactions separate and independent, ensuring their respective spirit distinct, with the help of a highly advanced, securitized, customized & user-friendly state of the art computer system.
Regarding the acceptability from the Shariah point of view, being a separate and independent module, fire-walled through appropriate software it should not have any complicacies. Shariah scholars have admitted this dual system subject to strict compliance and adherence to Shariah principles and Islamic values. If a full fledged Islamic bank can run in an Interest based economy, then why it should not be possible to run Islamic banking in an Interest based bank?
Present growth trend of Islamic banking in full-fledged as well as dual system is marvelous. Yet, particularly the implementation of Shariah-based banking in conventional banks obviously faces a lot of problems; but those are kept beyond the purview of the article for the sake of brevity. It is expected that if the present growth rate of the sector continues, it may not be far away when Islamic banking will make its dominance felt in mainstream banking. There must be a continuous supply chain of true Islamic bankers alongside awareness of the concept of Islamic banking among the entrepreneurs, government machinery, intellectuals as well as the masses.
There are ample examples in our banking industry where a potential Mudaraba depositor refuses to deposit his money with an Islamic window of a renowned conventional bank because the window could not mention the future fixed rate of profit on receipt of his Mudaraba term deposit. The client deposited the fund under the same Mudaraba principle in a full-fledged Islamic bank because the latter could assure in writing the fixed rate of profit he is to receive in future. Mudaraba principle stipulates to share profit according to ratio of actual profit earned for the period concerned. No predetermined rate can be offered.
Writer is the First Vice President and Head of Islamic Banking of Bank Asia Ltd. He can be reached at email afzal@bankasia.com.bd. Opinions expressed in the article are of the writer and not necessarily of the organization he is serving for
Honest Commitment of the authority: The authority of the bank concerned should be honestly convinced of the concept of Islamic banking and committed to it. Only committed management of a bank with honest support of Board of Directors can ensure complete compliance and commitment to Islamic banking. Again Shariah people are not usually available in all the phase of the banking operations. Authorities of the bank would hire the right human resources only when they are convinced and committed. If the target of Islamic banking merely covers expansion of business of the bank with a Shariah-signboard to attract a specific target group by any means without any honest commitment, it may jeopardise its aims and objectives. A fair policy of the committed management can ensure right direction for Islamic banking operations. Even a bank does at all not necessarily need to put the word 'Islamic' in its signboard. It is rather the belief, mission and action that will say whether it is truly Islamic or not. So, commitment of the authority plays a vital role in introducing Islamic banking operations in a conventional bank.
Recruitment and continuous development of competent human resources:
Human resources are important to implement any policy. It is, therefore, men behind the machine are actually responsible for production. So, selection of the right team in respect of competence, honesty, integrity as well as willingness to establish the ideology of Islamic banking will be the next vital step. Principle is to dominate over practice by the competent right bankers /operators. Appropriate personnel will thus be one of the key factors for introduction of Islamic banking particularly when operated in a conventional Bank.
Shariah compliance: Apart from recruitment of professional bankers, a bank wishing to offer Islamic products must appoint knowledgeable personnel to ensure shariah compliance in its Islamic banking operations. In this regard according to the recent Islamic Banking Guidelines of Bangladesh Bank, a bank may appoint a Shariah Supervisory Committee comprising, among others, qualified Islamic scholars. Shariah Scholars may be included in the Board of Directors of the bank, who is responsible to ensure Shariah compliance in their Islamic banking operations. This initial step is essential for the future of the bank, as it will help full compliance of Shariah.
Segregation of Islamic banking fund from conventional fund:
Operationally, the most important principle behind Islamic finance is the desire to maintain the moral purity of all transactions. The funds intended for Shariah-compatible investments should therefore not be mixed with those of non-Islamic ones. This requirement is, however, not based on the assumption that all the activities of a conventional bank or those of non-Muslims are intrinsically impure. The rationale behind this principle is rather one of prudence, in the sense of taking all the necessary precautions to ensure that Islamic funds are not mixed with other funds that may get involved in interest, or haram activities or close to them.
Therefore, in order to ensure compliance with Islamic principles, conventional banks wishing to offer Islamic products must guarantee and publicise that the funds devoted to conventional activities will not be mixed with those reserved for Islamic activities. In operational terms, this requires that banks establish different accounts, and reporting systems for each type of activity. In this case, when a conventional bank opens an Islamic unit it is, to a large extent, a separate entity from the rest of the bank. It is a bank within a bank. As such to run Islamic banking in parallel with conventional banking in a systematic way, there must be an Islamic Fund Manager maintaining separate general/settlement account for Islamic banking operations distinct from the conventional inter branch General A/c. Any transaction between an Islamic banking unit and a conventional unit shall be treated as Inter-bank (not inter-branch) transaction and be reconciled by the respective fund managers at the head office level. For reconciliation purpose they may create counter/corresponding settlement (Islamic Settlement in conventional unit and Conventional Settlement in Islamic unit) A/C.
Any transaction between the fund managers of conventional banking and Islamic banking at head office level shall also touch the corresponding Settlement A/Cs. Only transaction/s between two Islamic units shall be treated as inter-branch one and be titled as BIG (Bank's Islamic General) A/C. Finally it is the balance of Settlement A/C which would indicate whether Conventional or Islamic is the surplus unit for the day concerned.
Then the Balance of Settlement A/c may be treated as under: If the net balance of Settlement A/C for any month is in favour of conventional unit (Credit balance / borrowed from conventional) the same may be treated as if it were the deposit of conventional Bank kept in any Islamic Mudaraba Account with the Islamic Banking units. As in a Mudaraba Account, profit is shared according to predetermined Income Sharing Ratio (ISR) between the Bank and the client, profit to the conventional unit shall be paid on that amount at the rate attained as per ISR for that period by the concerned Mudaraba A/C holders as usual. Here the terms and conditions of operating Mudaraba A/cs as stipulated by the Islamic banking would be binding upon the conventional unit. Here the treatment is, as if conventional unit is one of many other depositors of Islamic Banking who open account therewith being fully agreed upon with the prescribed Shariah & other related terms and conditions. Rationale for the proposition is that Islamic Banks in general do not restrain any individual or institute from opening any Mudaraba (or any other usual) A/C with the Bank on the plea of the depositor's religious belief or obedience per se. So, if found otherwise ok, a Non-Muslim or any conventional Bank or institute can open/ maintain Mudaraba A/C with any Islamic Bank. Accordingly any such depositor has got every right to enjoy due share of Mudaraba profit from the Islamic Bank as long as he/it abides by the concerned Mudaraba A/C rules.
It would be very relevant to quote here from Shari'a Standards published (1425-26 H) by the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI, a Bahrain based institution established in 1990-1991) which issues internationally recognized Shariah standard on accounting auditing and governance issues. Under certain discipline it has also been opined to be permissible to run partnership business with non-Muslim or conventional banks. The spirit and reality must be practically reconciled with fair intention to keep the wheel of economy running rather than to stop it. "It is permissible for the institution to enter into a partnership contract with non-Muslims or conventional banks to carry out operations acceptable by Shari'a unless it has become evident that the funds or items presented by these entities for the purpose of the partnership are from non-permissible sources. In operating a partnership with non-Muslims or conventional banks, arrangements must be made to obtain all necessary assurances and guarantees that rules and principles of the Shari'a are observed during operations of the partnership. Among such guarantees is one to the effect that the operations of the company be either managed or supervised by an entity that observes the Shari'a rules Unquote (page 201). So it is rather better that bank or Islamic Bank itself becomes the Mudarib for onward fair utilization of the fund for maintaining sanctity."
If the net balance of the Settlement A/C is in favour of the Islamic unit (Debit balance/ lending to conventional unit) for any month, the sum of the daily product of the balance (instead of any profit amount) shall be carried over to the following month/s until complete set off by the corresponding credit balance of the product (sum of the daily product). But no such carry over of the sum of the product shall be made beyond the Annual closing. In case any debit balance remains on the eve of yearly closing the said product shall be nullified/ ignored henceforth without any return from the conventional side i.e. unavoidable use of Islamic Banking fund by the conventional unit is to be treated as Quard (certainly bearing no return thereon). Rationale for this proposition is to accept minimum level of gharar (uncertainty / deception) to refrain from haram (interest). To avoid such circumstances even, any surplus fund of Islamic Banking shall rather be duly placed to any Shariah based Bank or NBFI by the Islamic Fund Manager.
For fund transactions between two Islamic units no real profit shall be paid /received. But with a view to evaluating the individual performance of any specific Islamic unit, customary nominal rate of profit may be applied on Bank's Islamic General or BIG A/C. But in this case no differential rate would be applied for deficit and the surplus unit. This measure would ensure ultimate net balance arising from the same corresponding amount of such A/C nullifies each other.
By their very nature, Banks combine in their balance sheets short-term liabilities with long-term assets, resulting in maturity mismatches. Banks try to minimize the potential risks resulting from these mismatches by actively managing their liquidity needs, typically through inter-bank money markets. Given that conventional inter-bank markets are interest-based markets, Islamic banks cannot participate there to manage their liquidity positions, and therefore an alternative market design is required. One thing is to be made clear in this regard that segregation, rather management of fund in an Islamic Unit of Conventional Bank, is extremely important and of course, one of the most difficult as well as questionable issues. An Islamic Inter-bank Money Market is, therefore, of dire need.
Owing to absence of Islamic Inter-Bank Money Market, Islamic banks in conventional systems have, for years, operated with no access to tradable short-term treasury instruments through which excess funds can be channelled to other Islamic banks. This has restricted their growth potential by forcing them to hold substantial cash reserves. A suggestion of Bangladesh Bank to open Mudaraba SND A/c with each other of the Islamic banking operators may pave the way for development of an Islamic Inter Bank Money Market.
Compliance of Accounting & Auditing Standard: Following a standard brings uniformity in an industry allowing a level playing field for interpretation of respective position of all the participants/ units. As such a separate chart of Accounts (Conforming to a uniform Islamic Standard) is a must for Islamic banking in conventional banks. The need for a body of accounting standards purposefully designed to reflect the specialisation of Islamic products is a crying need for Islamic banking as new and more complex instruments are being marketed now-a-days.
Awareness Campaign: The speed and extent of success with which Islamic banking to emerge in conventional systems largely depend on whether potential clients are well informed about the opportunities and risks, and on whether Islamic banking is perceived as a transparent and well-regulated activity. Moreover, the doubt about practicability of Shariah compliance in the dual system will have to be removed through confident and intelligent arguments. This awareness campaign would also ensure compliance with Pillar-3 of BASEL-II. This pillar encourages banks to have market discipline/public disclosures such as to publicly provide details of relevant information vis-à-vis the amount & means of management of risk ensuring better transparency and confidence of the stakeholders.
Presentation of separate as well as consolidated statement of affairs: An independent, complete and separate books of accounts reflecting periodical activities and results along with a 'true and fair state of affairs' of Islamic banking units as a whole is to be had having a full chart of Accounts. Annual Report of the bank must integrate the full scenario of its Islamic as well as the conventional banking operations.
Controversy over sanctity of operating Islamic Banking in Conventional Banks: Although the phenomenon of Islamic banking operation in interest based banks has by this time got a momentum of its growing trend in the banking circle, disputes still remain whether the two types of transactions can be operated with their distinct spirit or if such arrangement is acceptable from Shariah point of view and so on. In this digital era, we must believe that it is technically feasible to keep the two different types of transactions separate and independent, ensuring their respective spirit distinct, with the help of a highly advanced, securitized, customized & user-friendly state of the art computer system.
Regarding the acceptability from the Shariah point of view, being a separate and independent module, fire-walled through appropriate software it should not have any complicacies. Shariah scholars have admitted this dual system subject to strict compliance and adherence to Shariah principles and Islamic values. If a full fledged Islamic bank can run in an Interest based economy, then why it should not be possible to run Islamic banking in an Interest based bank?
Present growth trend of Islamic banking in full-fledged as well as dual system is marvelous. Yet, particularly the implementation of Shariah-based banking in conventional banks obviously faces a lot of problems; but those are kept beyond the purview of the article for the sake of brevity. It is expected that if the present growth rate of the sector continues, it may not be far away when Islamic banking will make its dominance felt in mainstream banking. There must be a continuous supply chain of true Islamic bankers alongside awareness of the concept of Islamic banking among the entrepreneurs, government machinery, intellectuals as well as the masses.
There are ample examples in our banking industry where a potential Mudaraba depositor refuses to deposit his money with an Islamic window of a renowned conventional bank because the window could not mention the future fixed rate of profit on receipt of his Mudaraba term deposit. The client deposited the fund under the same Mudaraba principle in a full-fledged Islamic bank because the latter could assure in writing the fixed rate of profit he is to receive in future. Mudaraba principle stipulates to share profit according to ratio of actual profit earned for the period concerned. No predetermined rate can be offered.
Writer is the First Vice President and Head of Islamic Banking of Bank Asia Ltd. He can be reached at email afzal@bankasia.com.bd. Opinions expressed in the article are of the writer and not necessarily of the organization he is serving for