Banking In Islam

1. Banking In Islam

2. Monetary Policy Transmission Mechanism • The monetary policy transmission mechanism is a process through which monetary policy decisions are transmitted into changes in income and inflation (Taylor, 1995) • The process through which monetary policy decisions impact and economy in general and the price level in particular • The individual links through which monetary policy impulses proceed are known as transmission channels.

3. Monetary Policy Transmission Mechanism in Malaysia BNM’s MPC OPR Conventional Financial Market Islamic Financial Market Interest rate Profit rate Credit Financing Asset prices (bond yields) Asset prices (sukuk profit)

4. cont • The existence of a dual-banking system would produce two money markets concurrently; i.e. the bank operates the Islamic money market in parallel with the conventional money market. • The Islamic money market acts as a short-term intermediary to provide a ready source of investment outlets based on shariah principles. • Hence, the Islamic money market becomes an integral part to the functioning of the Islamic financial system in two ways:

5. cont • Facilitating funding and adjusting portfolios over the short-term • Providing a monetary policy channel

6. Cont • The objectives of monetary policy are to achieve its targets such as sustainable economic growth and instituting stable price. • It is important for policy makers to understand monetary transmission mechanism in order to influence economic variables. • Every monetary policy impulse has a slow impact on the economy. • The effect of such external factors e.g. supply and demand shocks, technical progress or structural change

7. The individual transmission channels: • Profit rate channel- • Causes demand to increase • Influences prices and wages to rise if goods and labor markets are fully utilized

8. The Bank financing channel • The bank’s monetary policy decisions influence Islamic banks’ refinancing costs; Islamic banks are inclined to pass the changes to their customers. • If financing cost diminish → investment and consumer spending ↑ contributing to an acceleration of growth and inflation

9. Exchange Rate channel • Mark up rates will push prices up hence, the exchange rate depreciates. • An expansionary monetary policy affects exchange rates because deposits denominated in domestic currency becomes less attractive than deposits denominated in foreign currencies when profit rates are cut • The value of deposits denominated in domestic currency declines relative to that foreign currency-denominated deposits and the currency depreciates. • This depreciation makes domestic goods cheaper than imported goods.

10. Wealth channel • Monetary policy impulses are also transmitted through the price of asset such as stocks and real estate. • The expansionary monetary policy effects of lower profit rates make sukuk less attractive than stocks and results in increased demand for stocks, which pushes up stock prices. • Profit rate reductions make it cheaper to finance housing loans, causing real estate prices to go up.

11. Asset price channel • There are two different types of transmission mechanisms involving asset prices (i) Investment effect (ii) wealth effect • (i) Investment effect- Tobin’s q theory can be the channel for monetary transmission affecting economic variables through the valuation of equities • Tobin defines q is “the market value of firms divided by the replacement cost of capital” (Mishkin, 1996). If the value of q is high then the company will invest more because the value of the firm is higher than the replacement cost of capital and otherwise.

12. From the above, money supply decreases in the economy because of monetary contraction. • Individuals would have less money than they want. • Therefore, in order to smooth their consumption they will try to sell their asset, securities for instance. • This will decrease the demand for stock thereby leading the price of stock to decrease. • Hence, the q value of firms falls. Firms will reduce their investments which will cause output to fall.

13. (ii) Wealth effect • Monetary transmission goes through wealth effect on consumption. • Based on life-cycle hypothesis model, consumption spending is determined by life time resources. • If the value of wealth increases permanently, this would also increase the consumption of individuals. • Monetary contraction affects the value of stock price to decline. Since most of the financial asset is common stock, the decrease of stock price leads to decrease of wealth. Therefore, the individual will decrease their consumption. As a result, because of the decrease in aggregate demand, output will fall.

14. Islamic Banking Historical Overview of Islamic Banking • The historical perspective of Islamic financial institutions can be divided into three phases. • The first phase started from the early years of Islam when it was first born in the city of Mecca, up until the period of Caliph ar-Rashidin. • The second phase began from the era of the caliphates until the fall of the Ottoman Empire. • And the last, which is the third phase, can be classified as the modern era of Islamic banking

15. Early Era • Mecca became the city of trade and business; commercial activities continued even after Islam became rooted there. • the banking activities were still scarce and the activities included the safe keeping of money and valuables. • Az- Zubair al-Awwam was entrusted to handle the safe- keeping activities during the era when Prophet (p.b.u.h) was still alive. • For example, (1) as recorded by Ibn Saad, Az- Zubair had introduced the Wadiah saving service. However Zubair did not accept any safe-keeping requests as he feared that the money would be lost and he could not use it.

16. Early Era • From the situation, in order to reduce his amount of responsibility, Zubair had asked to change the system, that was from Wadiah system to the borrowing and lending system which he thought would reduce his responsibility. • However, the result had been rather disappointing when Zubair suffered a large amount of debt since the borrowing and lending system was applied.

17. Middle Era • The middle era of Islam started with the end of the reign of Caliph Uthman in the year 661M. • The next was by Caliph Umaiyyah (661-750M) with Damsyik as the centre, followed by the reign of Caliph Abbasiyyah (750-1258) which center of administration located in Baghdad, the reign of Caliph Umaiyyah in Spain (756-1031M) and the period of the Ottoman Empire (1350-1918M). • However, during the Ummayyah Empire (661-750M), the landscape of financial institutions had changed due to the establishment of “Baytulmal”. • Baytulmal or the “House of property or Money” is known as the first Islamic financial institution.

18. Third Era • The collapse of the Ottoman Empire saw the colonialization of European banks in many countries. • For example, the establishments of the Standard Chartered Bank in Malaysia (1881), Algemence Bank in Indonesia (1826), the existence of Ottoman Bank (Osmanli Bankasi (1856)) which head offices were located in London and Imperial Bank of Persia was established in 1889 with a concession from the government of Persia. • However, the clash of civilization due to the riba-based financial institutions had motivated the idea of interest-free banking or widely known nowadays as Islamic financial institutions

19. However, in 1940’s, the first attempt to establish interest-free banking in Malaysia had become unsuccessful. Other interest free banks were in a rural area of Pakistan in the end of 1950s. This bank is known as the shariah bank since interest is not charged on the transaction • Furthermore, the establishment of Mit Ghamr Savings Bank in 1963 in one of the rural regions in the Nile Valley in Egypt marked the dawn of the modern era of the Islamic banking system and paved the way for the establishment of other Islamic banks. • During the establishment, this bank provided basic banking services such as deposit accounts, loan accounts, equity participation, direct investment and social services. The well-functioning and good performance of Mit Ghamr Savings Bank has become all the more reason for more Islamic banks to develop.

20. Concept of Islamic Banking • Islamic banking is interest free banking, in which there is no fixed rate of return. • Islamic banking is the banking system which is run in accordance with the Islamic laws and the Shariah board, that guides the institutions. • In Islam, the shariah law prohibits the collection and payment of interest (riba). As the replacement, profit-and-loss sharing arrangement (PLS), or purchase or resale of goods and services forms the basis of contract in Islamic law. Islamic law does not encourage economic activities that involve speculation (gharar) and prohibit investing in business that is haram. There are also zakat which is Islamic tax.

21. IB • Currently available Islamic Banking Products and services are: • Partnership based modes of financing • Musharaka Finance, Mudaraba Finance, • Trade based modes of financing • Murabaha Finance, Salam finance • Rental based modes of financing • Ijarah Finance, Diminishing Musharaka Finance • re • Partnership based modes of financing

22. Differences and similarity • THE DIFFERENCESS① • Business organization • Shariah prohibit from paying interest, • Use profit loss sharing, then encourage buying and selling and leasing⇒advantages①Improve the efficiency of Capital allocation②Ensure more fair distribution of wealth ③Raise the number of investments and create more jobs④Since the supply of money is not allowed to increase more than the supply of goods⇒Limit inflationary pressures in the economy

23. Differences and similarity • THE DIFFERENCESS② • Economic Rules • Create wealth that parallel to the objective of Shariah (Maqasid as-Shariah)⇒make sure the communities are well preserve and growth

24. Differences and similarity • THE DIFFERENCESS③ • Law Origin • Offer other workable legal framework (Shariah law) • The Shariah Law is based on beliefs and ideology which regulated by the concept of creation, its evolution, existence and final destiny. • Indirectly, the organizations of IFIs are more influence by the moral elements. • The moral elements exist from the factor of faith and belief and the ideology of Islamic principles on the Islamic operation.

25. Differences and similarity • THE SIMILARITY • Supervisory Role • IFIs are similar in term of Islamic Financial Services Board (IFSB) • Grouped stakeholders into eights bodies to run IFSB • The role of IFSB is similar to the roles played by three global standard-setters which are the followings: • Basil Committee for Bank Supervision • International Organizations of Securities Commissions • International Associations of Insurance Supervisors Roles of 3 bodies into 1 organization

26. THE IMPLICATIONS • The application of Islamic financial institution give some implication especially on financial landscape. • There are two implication which are multi-contracts and dual system. • Multi-contractsThe improvement of Islamic Financial Institution created many types of contracts on the transactions. This type of contracts happen since the demand of contractual agreement increased. • Dual systemThe evaluation of Islamic banking and finance created some innovation on the institution. This dual system is applied in the countries that apply Islamic and Conventional banking system parallelly such as in Malaysia and Bahrain.

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