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 Bangkok, Thailand October 2006 ISBN 974-9733-00-2Chairman, Thesis Committee 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 31 October 2006 Is hereby approved: Jud A obo 31 Od-2urg (Assoc. Prof. Dr. Pleampit Satsanguan) (Date) Member, Thesis Committee: Sh tales) (Assoc. Prof. Dr. Isra Sarntisart) ate) Dean (Assist. Prof. Dr. Kovit Chamvitayapong) (Date) “pon & Bi-to~o6, (Assoc. Prof. DratiponPoapongsakorn) (Date)ABSTRACT With the inception of Islamic banking practices in the mid-1970s academic discourses on the subject highlighted the profit-sharing features of Islamic financing. It was believed that Islamic banking would take the form of the two-tier mudarabah model. Experience, however, shows that there are some inherent problems in applying profit-sharing modes of financing (mudarabah and musharakah). The problems in the application of the profit-sharing model in practice led to the use of other financial instruments. Mark-up financing (murabaha) became the dominant mode of financing in Islamic banks (Iqbal et al., 1998; Khan, 1995). Studies exploring this phenomenon identify the moral-hazard problem in profit-sharing modes of financing as the main cause of its unpopularity. Though an Islamic economy cannot be a ‘pure profit- sharing’ economy, there is an aspiration among the proponents of Islamic banking to have a balanced mix between mark-up and profit-sharing modes of financing (Al Jathi, 1999). The success of the use of profit-sharing modes of financing, however, will depend on the resotution of the problems of asymmetric information associated with their use. In order for the share of profit-sharing finance in the financial system be increased, the features of a profit-sharing contract which are compatible with the incentive requirements of both suppliers and seekers of funds must be identified and incorporated in the contracts. With the purpose of exploring this possibility, the present study first focuses on the workings of Islamic banking system in the process of mobilization of savings and allocation of funds from the theoretical point of view. Then, it evaluates empirically current Islamic banking practice in the case of Islamic Banking Scheme (IBS) of Malaysia during 2001-2004. This is to identify whether the current practice is in conformity with the theoretical setting of Islamic banking system. With regard to the first objective, the present study investigates profit-sharing mechanism of Islamic banking on both sides of financial intermediation: mobilization of savings and allocation of funds. The theoretical part of the study concludes by summarizing the problems impeding profit-sharing such as: (1) The problem of asymmetric information and the costs involved in reducing it; (2) The problem of verifying, ex ante, the promises and intentions that are frequently involved in financial a