CHAPTER 1

INTRODUCTION TO ISLAMIC
BANK OPERATIONS
 DEFINITION OF ISLAMIC BANK
OPERATIONS
• An insightful definition is provided in the Islamic Banking Act,
1983 which defines ‘Islamic banking business’ as banking
business whose aims and operations do not involve any
element which is not approved by the religion of Islam.

• Islamic banking is a form of modern banking based on Islamic

legal concepts developed in the first centuries of Islam, using
risk-sharing as its main method, and excluding financing based
on a fixed, pre-determined return.
OVERVIEW OF ISLAMIC BANK OPERATIONS
• The origin of Islamic banking is Syariah, ie. Islamic law or sometimes
referred to as Islamic jurisprudence.
• The teaching of Islam encompasses the essence of economic
well-being and development of a Muslim at the individual, family,
society, state and ummah levels.
• Figure 1 - Islamic view of life of a Muslim and the place of his
economic activities.
• 2 main sources of references on Islamic Bank (IB) operations.
• Banking and financial activities - part and parcel of Islamic
Muamalat - therefore, subject to the Syariah Laws on Muamalat.
• In application, the use of Fiqh as a tool to interpret the main
sources, which in turn applies certain methodology - where the
scholars play a role.
SOME POINTS FROM THE SYARIAH
PERSPECTIVE
• General Rule is that, if it is not prohibited, then it is permissible
• Lending is allowed BUT…
✓ Only benevolent lending
✓ Dollar for dollar
✓ Riba is prohibited
FIGURE 1: ISLAM, SYARIAH, MUAMALAT, BANKING AND FINANCE

ISLAM

AQIDAH SYARIAH AKHLAQ

(Faith & Belief) (Practices & Activities) (Moralities & Ethics)

IBADAT MUAMALAT
(Man-to God Worship ) (Man-to-Man Activities)

POLITICAL ACTIVITIES ECONOMIC ACTIVITIES SOCIAL ACTIVITIES

BANKING AND
FINANCIAL ACTIVITIES
 FIGURE 2: FULFILLMENT OF FINANCING NEEDS

FULFILLMENT OF FINANCING NEEDS

Own capital Others’ capital

Equity Financing Debt Financing

 OBJECTIVES OF ISLAMIC BANK (IB)
• The existence of IBs is to promote, foster and develop banking
services and products based on Islamic principles.
• The main principle: prohibition of riba in all forms of transactions,
undertakings, businesses and trade activities.
• IBs are expected to profit from their operations. It is an injustice to
the shareholders if IBs are unable to provide reasonable returns.
• While ordinary business institutions place profit as primary
objective, IBs have to incorporate both profit and moral
consciousness into their objectives.
• Example: BIMB’s corporate objective: to provide banking
facilities and services in accordance with Islamic principles, rules
and practices to all Muslims as well as the population of
Malaysia.
 ROLE OF ISLAMIC BANKS
FIGURE 3: ROLE OF FINANCIAL INTERMEDIARIES (BANKS)

Surplus unit Return on investment

Individuals
Business
Savings &
Govt. investment
Financial
intermediaries (banks)

Financing
Deficit unit
Individuals
Business Return on financing
Govt.

Refer Dusuki & Abdullah (2011) Fundamentals of Islamic Banking, KL: IBFIM
 SOME ROLES OF IBS AS FINANCIAL
INTERMEDIARIES
1. To overcome market imperfection by reducing the
transaction costs (eg. searching cost, screening cost,
monitoring cost, etc.)
2. To overcome the issue of information that is not symmetrical,
where a person has insufficient knowledge about parties
involved in the transaction to make an accurate decision.
3. As facilitators of risk transfer in dealing with the increasingly
complex maze of financial instruments and markets.
Four rules govern investment behaviour:
1. the absence of interest-based (riba) transactions;
2. the avoidance of economic activities involving speculation
(gharar);
3. the introduction of an Islamic tax, i.e. zakat;
4. the discouragement of the production of goods and
services which contradict the value pattern of Islam
(haram).
FUNCTIONS OF ISLAMIC BANKS
Two types:
1. Fund based
• Primary functions, i.e. acceptance of deposits from savers
and lend money to deficit individual/institutions.
• Accepts deposits against savings and current account - to
generate income under specific investment account or
general investment account.
• May receive deposits from customers under current account.
• IBs lend money to borrowers for short-term, medium-term and
long-term investments.
• Depositors, IBs and borrowers share risk of loss according to
sales contracts.
FUNCTIONS OF ISLAMIC BANKS
2. Non-Fund based
• Agency services or general utility services
• As an agent to provide different types of services, eg.
collection of cheques, purchase/sale of securities, execution
of standing orders, etc.
• General utility services, eg. collection of utility bills, foreign
exchange remittances, ATM services, etc.
 FIGURE 4: FUNCTIONS OF ISLAMIC BANKS

General Investment Specific

Fund Investment Fund

Accept
Deposits

Fund Based Services

Non-Fund Based

ISLAMIC BANKS
Services

Agency &
Primary
General Utility
Function
Function
Advance Loans
(Financing Products)

Long term Short term

Medium term Murabahah
Musyarakah
Ijarah Bay’ salam
Mudharabah
Ijarah thumma al-bay’ Istisna’
 OPERATIONAL PRINCIPLES OF ISLAMIC BANKS
• Basic-known principle of IB is the prohibition of riba.
• The Quran forbids the charging of riba on money lent.
• References in the Quran on the prohibition:
 Surah Ar-Rum, verse 39:
“And whatever riba you give so that it may increase in the
wealth of the people, it does not increase with Allah”.
 Surah An-Nisa’, verse 161:
“And because of their charging riba, whilst they were
prohibited from it”.
 Surah Ali-Imran, verse 130:
“O those who believe do not consume up riba, doubled and
redoubled”.
(a) Contract of profit sharing:
• Mudharabah
• Musyarakah

(b) Contract of Sale:

• Ijarah
• Jua’lah
• Murabahah
• Bay’ Salam
• Istisna’
• Qardhul hasan
• Bay bithaman ajil
• Bay’ As-Sarf
(c) Contract of Deposits
• Al-Wadiah

(d) Contract of Wakalah

(e) Contract of Hibah

(f) Contract of Security

• Al-Kafalah
• Al-Hawalah
• Ar-Rahnu
THE MOST USED PRINCIPLES IN IBS:

• BBA
A contract that refers to the sale and purchase transaction for the financing of assets on a
deferred and an instalment basis with a pre-agreed payment period. The sale price will include
a profit margin.

• Ijarah
A contract which effects in the transfer of the right to use (usufruct).

• Qardhul Hassan
A contract of loan between two parties on the basis of social welfare or to fulfil a short-term
financial need of the borrower. The amount paid by the borrower at the end of the period is
the same borrowed amount.

• Mudharabah
A partnership in profit whereby one party provides capital and the other party provides skill and
labor.
• Ijarah
A contract between two parties: the lessor and lessee, where the lessee enjoys or reaps a
specific service or benefit against a specified consideration or rent from the asset owned by the
lessor.

• Jua’lah
A kind of contract of hiring for services, in which one party undertakes to pay a specified
amount of money for rendering a defined service in accordance with the terms negotiated
between them.

• Bay’ Salam
A kind of sale, which is practiced based on general principles of contract of sale, in which the
buyer pays for the goods in advance while the goods are to be delivered later.

• Istisna’
A contract for the acquisition of goods by specification or order.

• Wadiah
A kind of contract whereby a person leaves his valuable in the custody of others, in trust for safe
keeping.