Bachelor Thesis - Islamic Banking

University of Economics in Prague
Faculty of Finance and Accounting
Department of Banking and Insurance
Study program: Banking and Insurance
Islamic banking
Author: Jakub Bláha
Supervisor: Ing. Vladislav Vacek
Year of defence: 2014

Declaration:
I hereby declare that this bachelor thesis is my own work and that the information I used has
been fully acknowledged in the text and listed in the bibliography.
Prague, date: ...………………………..
Jakub Bláha

Acknowledgments:
I would like to thank the supervisor of my bachelor thesis, Ing. Vladislav Vacek for his
helpfulness, stimulating suggestions, reminders and patiance.
Poděkování
Na tomto místě bych rád poděkoval vedoucímu své bakalářské práce, Ing. Vladislavu
Vackovi za vstřícnost, podnětné rady, připomínky a trpělivost.

Annotation:
The aim of this bachelor thesis is to introduce the Islamic banking. Describing historical and
religious background of Islam, the Islamic banking and Shari’ah law. Then presenting financing
techniques used in the Islamic banking. Eventually describing and analysing the Islamic
banking in Malaysia. Comparison between the Islamic banking and the conventional banking
is given throughout the bachelor thesis.
Key words: Islamic banking, Islam, Shari’ah, financing techniques, Malaysia, conventional
banking
Anotace:
Cílem této bakalářské práce je představit islámské bankovnictví. Popsat historické a
náboženské pozadí Islámu, islámského bankovnictví a práva Šaría. Poté prezentovat techniky
financování používané v islámském bankovnictví. Nakonec popsat a analyzovat islámské
bankovnictví v Malajsii. Srovnání mezi islámským a konvenčním bankovnictví je poskytnuto
v průběhu celé bakalářské práce.
Klíčová slova: islámské bankovnictví, Islám, Šaría, techniky financování, Malajsie, konvenční
bankovnictví

Contents
Introduction............................................................................................................................................. 7
1 The Islamic banking Framework...................................................................................................... 9
1.1 Historical background of Islam............................................................................................... 9
1.2 Religious background of Islam ............................................................................................. 11
1.2.1 Beliefs (Aqidah):............................................................................................................ 11
1.2.2 Morals (Akhlaq): ........................................................................................................... 11
1.2.3 Duties (Sharia’ah): ........................................................................................................ 12
1.3 Shariah .................................................................................................................................. 12
1.3.1 Man-to-man activities (Muamalat Ammah): .............................................................. 12
1.3.2 Sharia’ah in Islamic banking:........................................................................................ 13
1.4 Prohibitions in Islam............................................................................................................. 13
1.4.1 Halal and Haram........................................................................................................... 13
1.4.2 Riba (Prohibiton againts interest):............................................................................... 14
1.4.3 Gharar (prohibition against uncertainty): ................................................................... 14
1.4.4 Maysir (prohibition against gambling):........................................................................ 15
2 Techniques of financing in the Islamic banking............................................................................. 16
2.1 Profit loss sharing techniques .............................................................................................. 16
2.1.1 Mudaraba...................................................................................................................... 16
2.1.2 Musharaka .................................................................................................................... 17
2.2 Profit mark – up techniques................................................................................................. 19
2.2.1 Murabaha...................................................................................................................... 19
2.2.2 Ijarah ............................................................................................................................. 19
2.2.3 Istisna ............................................................................................................................ 20
2.2.4 Salam............................................................................................................................. 21
2.3 Sukuk..................................................................................................................................... 21
2.4 Takaful................................................................................................................................... 24
2.5 Zakat...................................................................................................................................... 26

2.6 Current and Saving Accounts ............................................................................................... 26
3 Comparison of growth of islamic and conventional banking in the example of Malaysia............ 28
3.1 Introduction of practical example........................................................................................ 28
3.2 Malaysian Islamic financial sector ....................................................................................... 28
3.3 Comparison of asset growth and profitability..................................................................... 30
3.3.1 Asset growth comparison............................................................................................. 30
3.3.2 Profitability comparison............................................................................................... 35
3.3.3 Analysis summary......................................................................................................... 38
Conclusion ............................................................................................................................................. 40
4 Bibliography................................................................................................................................... 42
5 Annex............................................................................................................................................. 42

Introduction
Islamic finance or more commonly used term Islamic banking has been shaping itself and the
economies it serves for almost five decades. It has begun to spread after decolonisation in Egypt
and in Malaysia, and then after being internationally acknowledged in 1973 by Muslim
community in the form of the Islamic Development bank, it was clear that Islamic countries
wanted for their citizens a financial system that would be simply in harmony with their daily
life activities, their beliefs, their morals, just in harmony with their religion, Islam.
The Islamic banking has started to gain greater popularity and recognition during and after the
Financial crisis of 2008 which shown big imbalances in the global economy. For being more
conservative than the conventional banking, the Islamic banking proved more resilient. In the
established Shari’ah law legal framework equity risk sharing is encouraged instead of debt
financing, riba (interest) is prohibited as well as speculation. With more than billion Muslims
across the world, the market for Islamic finance is huge and because Islamic banks were built
as retail banks, they were again more stable not being exposed to corporate sector. Being the
fastest growing financial industry in the world, the Islamic banking is now attracting attention
not only in Arabic or South-Asian countries, Europe itself has immense Muslim community
which demands islamic financial products. But Islamic banks serve non-Muslims the same as
Muslims offering an alternative to those seeking new ways for handling their finances1
.
The first chapter of this thesis is introducing Islam not only as a religion but also as a way of
living a life. Providing a description of historical background since the foundation of Islam to
its presence, then a description of religious background with focus on Shari’ah which means
duties to God and other men and prohibitions which are very important in the Islamic banking
approach.
The second chapter aims to describe islamic techniques of Shari’ah compliant financing that
are either profit and loss sharing or with a profit mark-up. As well as presenting sukuk, takaful,
zakat and forms of current and saving accounts.
1
IMF Survey: Islamic Banks: More resilient to crisis?. International Monetary Fund [online]. [cit. 2014-05-17].
Dostupné z: https://www.imf.org/external/pubs/ft/survey/so/2010/RES100410A.htm

The last chapter is introducing the Islamic banking in one of the most pioneer countries,
Malaysia. The goal of the practical example is to characterize the development of the Malaysian
Islamic financial sector with a hypothesis – Is the Islamic banking really growing more rapidly
then the conventional banking in Malaysia? An analysis of asset growth and profitability
between Islamic and conventional banks in Malaysia will be provided supplemented with own
reasoning.
The overall aim of this bachelor thesis is to introduce and compare the Islamic banking with
the conventional western banking in its approaches to financing.
Throughout this bachelor thesis only online sources and international eBooks were used mainly
from ebrary Business & Economics provided by the Universty of Economics in Prague. Online
sources consist of studies of International Monetary Fund and Ernst & Young company, then
of websites of certain Islamic banks and institutions such as the Islamic Development Bank,
Bank Negara Malaysia etc.
Basic ratios of asset growth and profitability used in the analysis ware taken from a study made
by Ernst & Young. The analysis itself was created on the basis of statements of financial
position and statements of income according to IFRS2
. Ratios of total assets, equity and
profit/loss for a certain year were used for the charts.
This topis was chosen because of my interest in new alternative ways of financial systems. The
Islamic banking is quintessentially based on solidarity which is, in my opinion, a path that
should be followed hand-in-hand with competition to create more equitable and resilient
economies.
2
International Financial Reporting Standards

1 The Islamic banking Framework
To fully understand and describe the world of islamic finance, we need to look to the history
and at the basic religious principles which has been shaping this approach to finance in general
for almost fifty years.
1.1 Historical background of Islam
Islam is an Arabic word which means ‚peace and submission to Allah‘. A follower of Islam is
called a Muslim. A Muslim strives to live in peace and harmony with the Creator, one self, other
people and the environment. (Abdullah & Chee, 2010, p. 55)
It all began when Allah revealed himself to prophet Mohammed through archangel Gabriel in
610 in Mecca. This revelation continued for 23 years until Mohammed’s death at the age of 63
and it is known as the Holy Koran. During that time Mohammed and his followers were forced
to flee Mecca. They left for Medina, this event marks the beginning of the Muslim calendar.
Before they were allowed to return to Mecca to finally establish the new religion, most of Arabia
was Muslim.
Muslims then divided into two groups that are called Sunni and Shiite. Sunni, when translated
meaning tradition, recognise four schools of theological law – Hanbali, Shafi’i, Maliki and
Hanafi and accepts that caliphs are the successors of Mohammed because he chose them
himself. 85% of Muslims are Sunni, when each school accepts the validity of the other three
and a Muslim can choose any one of them. Shiite is the second group counting for 15% of
Muslims. Shiite believes that any leader of Muslims has to be a direct descendant of
Mohammed’s daughter Fatima and her husband Ali3
.
3
CHEE, Daud Vicary Abdullah and Keon. Islamic finance why it makes sense [online]. Singapore: Marshall
Cavendish Business [cit. 2014-03-29]. ISBN 978-981-4312-448.

The reason why the islamic financial system has not been developing for a much more longer
period is that most of the islamic world was colonised by european nations. European masters
came with their own traditions, current western financial system being one of them. After
decolonisation in the second half of the 20th
century, muslim countries started to create
institutions that would serve them as normal banks do but which would be in compliance with
their religion and beliefs. First two banks were set up in 1963 in Egypt and Malaysia mainly to
offer a possibility for Muslims to save up for a voayge to Mecca4
.
In 1975 the Islamic Development Bank was established by the international community of
muslim countries as a reaction to the 1973 oil shock5
. The purpose of the Bank is to foster the
economic development and social progress of member countries and Muslim communities
individually as well as jointly in accordance with the principles of Shari'ah i.e., Islamic Law
(About IDB: Islamic Development Bank, 2014). Since then the IDB has been helping to create
new islamic institutions around the world.
To develop an international stable financial system, islamic institutions, especially banks,
needed to standardize their practices because scholars can have different opinions on what is
Shari’ah compliant and what is not. So the Accounting and Auditing Organization for Islamic
Financial Institutions (AAOIFI), the Islamic Financial Services Board (IFSB) and the
organisation of International Islamic Financial Market (IIFM) were created to issue standards
on accounting, to regulate and supervise the markets and to standardise the products and their
marketability respectively.
The 2008 Subprime crisis had a major influence on the development of islamic finance. As
liquidity freezed, capital of many banks declined and credit was difficult to obtain. This was
the time when islamic financial institutions stroke. First advantage was cheap capital as Arabic
countries owe huge sources of oil. Then they has been creating and adjusting products which
are similar to conventional ones in order to be able to compete with them. Finally Islam is the
second largest religion in the world, projected to surpass Christianity during 21st
century,
offering huge market to serve.
4
Cavendish Business [cit. 2014-03-29]. ISBN 978-981-4312-448.
5
Cavendish Business [cit. 2014-03-29]. ISBN 978-981-4312-44

1.2 Religious background of Islam
Islamic society and institutions must be in compliance with Islamic Law which originates from
two divine sources, the Holy Koran (Words of God) and Hadith (Words and deeds of
Mohammed). Every Muslim is defined by Koran because it covers law, worship, doctrine and
wisdom and also gives instructions for equitable, prosperous economic system, solidar society
and social and religious inclusion. Hadith can be explained as a guideline for Muslim in how to
live their daily lives. It is a recorded history of Mohammed’s life who was trusted by Allah to
explain, interpret and live the teachings of the Holy Koran.
To sum up the facts that are written above, Islam is a complex of laws. It says how to behave
in social, political and economic environment.
There are three areas that are regulated by the Holy Koran and Hadith. Beliefs (Aqidah), Duties
(Sharia’ah) and Morals (Akhlaq).
1.2.1 Beliefs (Aqidah):
Aqidah are those matters over which Muslims have conviction. There are six aspects of belief.
These beliefs are clearly articulated in the Holy Qu’ran as required of a Muslim:
1) Belief in Allah
2) Belief in the Prophets and Messengers sent by Allah, including Jesus, Moses and
Abraham.
3) Belief in the Angels. The Angles maintain a record of the actions and thoughts of each
human.
4) Belief in the Scriptures sent by Allah , including the Holy Qu’ran and the Hadith.
5) Belief in the Day of Judgement. On this day, all the people throughout the history of
mankind will be brought forth for accounting, reward and punishment.
6) Belief in Fate. A man’s fate is established by his own actions and thoughts.
(Abdullah & Chee, 2010, p. 66)
1.2.2 Morals (Akhlaq):
Akhlaq is the practice of virtue and morality. (Abdullah & Chee, 2010, p. 67) Islam teaches that
human perfection is determined by discipline and effort. If a Muslim wants to surpass the
Angles, he or she pursuits morals.

1.2.3 Duties (Sharia’ah):
Shari’ah defines duties that should be adopted by individuals on a path to Allah. It covers all
aspects of life such as commercial transactions, social behavior and faith. Two main categories
are covered by Shari’ah, man-to-God activities and man-to-man activites.
1.3 Shari’ah
For purpose of this thesis, man-to-God activites are not going to be covered as they are not
directly connected to the theme. The focus on man-to-man activites, called in Arabic Muamalat
Ammah, is stressed because these activites have a vital influence on Islamic finance.
1.3.1 Man-to-man activities (Muamalat Ammah):
There are five categories of human action that are relevant to commercial transactions, broadly
described as obligatory (Belief in God), recommended (kindness), permitted (doing business),
discouraged (divorce) and forbidden (gambling) (Abdullah & Chee, 2010, p. 70).
All actions taken by Islamic institutions, in this case banks, have to be in peace with Shari’ah
or said with more well-known term – Shari’ah compliant. Sharia is an Arabic word meaning
the path to be followed. (Kettel, 2011, p. 13) Path believed by all muslims to be the path shown
by Allah to Mohammed. Thus it is believed by Muslims that only Shari’ah liberates them from
servitude to other then Allah so that is the reason why Muslims are obliged to strive for it.
There are four sources of Shari’ah:
 the Holy Koran,
 the Sunnah (the Practice of Prophet Mohammed),
 Ijma – consensus of opinion ot the Ulema,
 Qiyas which are analogical deductions.
As explained above, the entire nation of Islam lives under the Shari’ah law. There is a council
of jurists which creates and interperts the Holy Koran and the Sunnah meaning that only these
men have the power and responsibility to make new laws according to Shari’ah. These religious
bases give a nonsided new laws, because these jurist creates laws which favor no politicians or
lobbyists but on the contrary should be in favor of people as a whole.

1.3.2 Shari’ah in Islamic banking:
Islam encourages all aspects of well-being meaning that economy is not an exception.
According to this religion economy should develop and serve the society so that there is no
poverty, the development should be done via trade so the financial system in general must
support the real economy through financing halal activities.
Islam bannes a lot of activites which are normal for us, citizens of the West (USA, Japan, EU),
such as speculation but that is going to be explained later. To create a financial system, one
must have an institution, in this case an Islamic bank and products. The products that are used
by Islamic financial instituions have to be Shari’ah compliant meaning they have met all the
Islamic legal requirements. To ensure this, Islamic banks always appoint a Shari’ah supervisory
board which is comprised of scholars, independent professionals educated in Islamic legal
system, who guide and provide the supervision of the products and the bank itself. This
committee certifies products and says if the transactions and dealings set up by its bank are
permissible.
1.4 Prohibitions in Islam
Historically, Islam has origin in the Middle East in Medieval times where most of Arabians
were traders thus money is to be invested into real assets. Trade and partnerships are encouraged
as well as risk sharing. Islamic finance is focused on serving its clients through creating value
in the real economy.
1.4.1 Halal and Haram
The principles of halal (allowed or lawful) and haram (prohibited or unlawful) are applied in
a Muslim’s daily activites, including in food consumption, for the good of the individual,
society, nation and humanity. (Kadir, 2007)
Every action done by Muslims that is for example unselfish or kind is halal. On the contrary
when acting in a destructive behavior to themselves, the environment or other people, these
actions are haram. Basically every unjust, harming or destructive actions are haram.

Examples of haram (single examples, sectors connected to these examples are haram as well):
 Alcohol,
 Prostitution,
 Producing and selling drugs,
 Manufacturing of weapons,
 Tobacoo,
 Pork,
 Riba,
 Gharar,
 Maysir.
1.4.2 Riba (prohibiton againts interest):
According to Sharia Law and the Holy Koran money are viewed only as a measuring tool for
value of assets but they are not an 'asset' themselves meaning that it is not possible to earn
income from money alone. Businesses are encouraged to increase wealth through trade, not
from borrowing and lending.
In Muslim countries, riba is considered exploitative because interest is earned from a borrower
without providing anything in return. In long-term interest-based financing can, if not handled
right, increase gap between poor and rich. For example in debt financing for business,
conventional banks require an asset as a collateral to hedge the risk but these practices tend to
favor bigger and established firms and the smaller ones are charged higher interest rates or
denied financing. This causes that bigger firms are getting bigger and the small ones have more
difficult conditions to finance themselves.
1.4.3 Gharar (prohibition against uncertainty):
In Arabic, uncertainty is called gharar. The term is not precisely defined, it also means hazard
or risk. Generally investment returns arisisng from an asset, such as a business or a stock, could
be either negative or positive meaning that certain level of gharar is allowed. Gambling and
speculation based on excessive gharar is prohibited. Speculation on stock prices, currency
movements or commodities is banned because it does not create any value in the real economy.

To remove Gharar form transactions, the conditions such as price or subject of the transactions,
should be clear between both parties.
Concepts in which gharar can occur:
• Uncertainty of ownership: A good example in conventional finance could be for
example short selling, a speculation on currency movements when the speculator does
not owe money needed for the speculation,
• Inadequacy of information: In islam, the weaker party should be protected from
irrelevant or insufficient information. All parts of a contract are clear meaning that all
information were revealed, price is fair, characteristics of an item are relevant,
• Conditional contract: The sale price of an item or service cannot be dependent on an
event that may not take place. Contracts cannot be interdependent, combined or linked.
Islamic finance differs from the conventional financial system concerning gharar in two ways.
Firstly in insurance sector where insured event can never occur or on the other side can occur
immediatelly. Secondly in financial derivatives where objects serving as a base for a contract
may not exist at the time the contract is executed.
1.4.4 Maysir (prohibition against gambling):
In Islam maysir is seen as a situation where one of two parties either win or lose. Casinos,
gambling machines, all of that is prohibited in Islam. It is an unjust enrichment of one side, it
also widens the gap between rich and poor. Concerning the finance, if simplified, gambling
could be identify in the stock market. If used for investment, Islamic finance does not have any
problem with stock market because the investor becomes one of shareholders, he buys an asset
on a risk sharing platform. But the stock market is also a place of excessive speculation where
an individual is able to earn huge amounts of money on betting if a price of a stock will go up
or down. Shari’ah compliant Islamic banks are investors not speculators.

2 Techniques of financing in the Islamic banking
Because of the prohibition of interest and speculation, islamic banks had to find new ways how
to transfer funds from depositors who are called investment account holders (owners of capital)
and business owners. Two methods were developed. First one is profit and loss sharing method
that includes Mudaraba and Musharaka and the other one is very similar to conventional
banking and includes Murabaha, Salam, Ijara, Sukuk etc.
2.1 Profit loss sharing techniques
2.1.1 Mudaraba
In general Mudaraba is a trade conract in which a Mudarib (business owner) is provided with
capital by a Rabb ul Mall (investor) for an agreed fee. It is characterized as a partnership
between two or more parties.
In this case an investment account holders provides via Islamic bank capital to Mudaribs. Then
the profit is shared in pre-agreed ratios, any loss on the other hand are borne by the Islamic
bank meaning that the bank bares the whole monetary loss. The loss is then transferred to
investment account holders. In mudaraba contract, Rab ul Mall sets the profit sharing ratio
which is in percentages not fixed. The ratio is adjusted to conditions concerning the type of
business invested in, place where Mudarib run the business and other things that could have an
influence on profit.
Shari’ah treats mudaraba in a way that the owner of capital (Islamic bank or actually
investment account holders) has no say in the usage of money provided to business. The whole
responsibility is put into Mudarib, Islamic bank can only specify conditions in order to ensure
better management of the capital.
There are two types of mudaraba:
 Restricted mudaraba (Mudaraba Al Muqayyadah): In this case Rab ul Mall (owner of
capital) can specify a particular choice of investment for Mudarib,
 Unrestricted mudaraba (Mudarab Al Mutlaqah): Full freedom is given to Mudarib by
Rab ul Mall in how to invest the capital, however it is forbidden to invest outside of the
normal routine of the business. If Mudarib wishes to do that, he or she must get a
permission by Rab ul Mall.

Two-tier Mudaraba:
As shown before, mudaraba is a two party contract. Islamic banks reshaped mudaraba so that
they could use in their ordinary activites. They have extended it to include three parties. Islamic
bank is a Mudarib opposite to its depositors (investment account holders) and it is a Rab ul Mall
opposite to the business sector.
 The funds are received on the basis of unrestricted mudaraba so that there are no limits
imposed on the Islamic banks while doing their daily activities. They can use all the
funds together and work as an intermediary. But they must avoid haram investments
(alcohol, drugs, speculation). On the contrary banks use restricted mudaraba when
approaching the business sector in order to specify the kind of activites, duration of the
investment etc. But as mentioned before they cannot interfere after the funding is
provided,
 Because mudaraba is a partnership, the Islamic bank trusts the investment decisions it
makes but with a possibility of future losses. It is forbidden to ask Mudaribs for
collateral or any other type of guarantee. The base of this system is solidarity.
Investment account holders take in account that they could lose their money,
 Islamic bank then uses the pooling technique to aggregate all profits and share them
with depositors after deducting all costs. When losses occur depositors lose a part of
their funds.
2.1.2 Musharaka
Musharaka is a form of partnership between an Islamic bank and its clients whereby each party
contributes to the partnership capital, in equal or varying degrees, to establish a new project
or share in an existing one, and whereby each of the parties becomes an owner of the capital
on a permanent or declining basis and is owed its due share fo profits. Losses, however, are
shared in proportion to the contributed capital. It is not permissible to stipulate otherwise.
(Kettel, 2011, p. 77)
One form of musharaka is called Mufawada which means unrestricted, unlimited and equal
partnership. All partners are put at the same level in management, capital and ownership. Each
partner guarantees the others and is also the agent of others.

But the most common form of musharaka is shirkah al’inan. Parties involved create a capital
fund in form of money or for example labour in order to execute a project. The parties only
guarantees themselves, however they are not agents of one another. Profit is then shared in pre-
agreed ratio in percentages, never fixed. However losses are always borne according to the
capital contributions.
There are two forms of musharaka:
 Constant musharaka in which a contract has unlimited time expiratio,
 Diminishing musharaka in which capital of the Islamic bank constantly decreases to
zero. This type of musharaka is more commonly used.
Mudaraba is used for financing short-term investment while musharaka is used for long-term
investment. The differences are when a loss occurs, in musharaka the entrepreneur is prepared
to share it with the Islamic bank.

2.2 Profit mark – up techniques
2.2.1 Murabaha
Murabaha is originally a sale contract that can be explained as sale on profit. In this type of
contract a buyer appoints a seller who is supposed to buy an item for him with pre-agreed profit
margin. The buyer must know the cost price as well as the profit margin.
Applied in the Islamic banking, murabaha became the most used financing mode. The concept
is that Islamic bank purchases an item for its clients with a profit margin or more commonly
used ‘mark-up’ to its cost. Islamic bank is the owner of the item which is after that provided to
its client. To secure itself, Islamic bank can require a collateral in a form of a different asset or
the item itself but only in case when no other asset exists. The repayment is then done via agreed
installments, paid immediately or delayed until the client resells the item.
According to Shari’ah an item has to be resold so that murabaha fulfills a fact that it is a sale
contract. Other condition is that Islamic bank really purchases the item and becomes an owner
of it.
However when a client is unable to repay an item of his or her desire, Islamic bank cannot
request any further mark-ups. When a default occurs, in practice after two non-paid
installments6
, Islamic bank can request all the others due to a certain date or charge a penalty
which then has to be used for covering costs connected to the purchased item or for charity.
2.2.2 Ijarah
Ijarah is originally a sale contract of an usufruct, an object or a hire of personal services. Ijarah
when translated means lease or hire. It is then a leasing contract. Assests such as merchandise
and property can be leased but for a shorter period of time then its useful life meaning they can
be leased multiple times.
Ijarah is widely used in islamic financing because no debt is created and furthermore it contains
a collateral. The lessor has to be the owner of the leased object while the lease takes place
meaning the lessor uses the leased object as security in the form of collateral. When a delay or
default occurs, the lessor is entitled to take back his or her ownership.
6
IQBAL, Zamir a Abbas MIRAKHOR. An introduction to islamic finance: theory and practice [online]. 2nd ed.
Singapore: John Wiley, c2011, xiv, 406 p. [cit. 2014-04-13]. ISBN 9780470828106.

Ijarah is very popular amongst conventional investors because it is almost the same as
conventional leasing. Differences are that a leasing agency, in this case Islamic bank, must own
the object as said earlier and the fact that no extra interest, while comparing the Islamic banking
and the conventional banking, can be charged when an installment is delayed or the lessee is
no more able to pay back his or her liability.
In murabaha, the ownership of an object changes. When the agreed amount is repaid, the object
becomes the property of the client. However in ijarah, the object remains the property of the
lessor, in this case Islamic bank. It means that they are higher administrative costs in a form of
taking care of the object and in a form of usage of the object once the contract is terminated.
This led Islamic banks to seek an improved contract so Muslim jurists developed a contract
called Ijara wa ‘qtina’ which is essentially a hire-purchase agreement. The object will be sold
for pre-agreed price to the lessee by the lessor at the end of the agreement.
2.2.3 Istisna
It is one of the basic conditions for the validity of a sale in Shari’ah that the commodity
(intended to be sold) must be in the physical or constructive possession of the seller. There are
only two exceptions to this general principle in Shari’ah. (BLOM, 2010) And one of them is
Istisna.
Istisna is a type of contract that is used in manufacturing and construction. There are two parties,
the buyer and the manufacturer. The buyer places an order for an item or a building and then
pays in advance, in installments or after the item is delivered. These three possibilites of
repayment scheme give Istisna the advantage in the form of flexibility.
When striking the contract the parties must agree on specifications of both the contract and the
item. After the manufacturing process begins, it is impossible to retrieve the order. Finally the
goods is delivered but when it does not conform the contract, the buyer has a possibility to
cancel the order.
Istisna is used especially for financing bigger projects in for example heavy industries such as
ship-building, aircraft and locomotive manufacturing or in construction industry for building
buildings or infrastructure.

2.2.4 Salam
Salam is a contract involving the purchase of a commodity for deferred delivery in exchange
for immediate payment according to specified conditions, or the sale of a commodity for
deferred delivery in exchange for immediate payment. (Kettel, 2011)
Salam is essentially a purchase of an item at spot while the item is delivered later in the future
according to the agreement. That means that Salam contains gharar so it should be banned to
enter into such a contract. For those reasons prophet Mohammed permitted salam while
fulfilling certain conditions. This contract was used specially in agriculture for financing
farmer’s needs between harvets. Because they could not take a loan for their needs, it was
allowed that farmers could sale their harvest or other agricultural products in advance. Salam
is recorded in Hadidth, thus it is valid and Shari’ah compliant according to Muslim jurists.
There are some conditions that have to be adrressed in salam. Firstly, the price for the goods
should be paid fully at spot. Then the commodities, for which salam is used, are in general
interchangeable meaning that a carrot can be replaced by a potato, a different item but still in
the category of food. At last, the place and date of delivery must be set in the contract.
As said before, salam is Shari’ah copmliant when used in the agriculture sector. It is basically
the best way of financing small farmers and can be also used as a form of microfinance. For
making a profit, the Islamic banks use the level of price. They fix the price at a lower rate than
the price of the commodity would normally be when delivered at spot at the moment of entering
salam. The difference between the two prices is then used as a profit.
2.3 Sukuk
Sukuk is a financial instrument that is used primarely in capital markets and it is an alternative
to conventional bonds. Sukuk is a plural form of a word ‘sak’ which also served as a base for
word ‘cheque’ meaning that Muslim traders have been using sealed papers in a form of
obligations since the Middle Ages.
The Accounting and Auditing Organization for Islamic Finance (AAOIFI) defines Sukuk as
investment certificates. All the certificates have equal value and represent shares in undivided
ownership of an underlying assets. These underlying assets may be represented by tangible
assets, usufructs or assets of a special investment project but they have to generate revenues.

It can be already seen that a main difference between sukuk and conventional bonds is the
nature of the products while bonds are debt obligations, sukuk represents an ownership claim.
(Fundamentals of islamic money) The most important advantage of sukuk compare to other
islamic products that were already described here is its liquidity as the ability to be traded in
the secondary market. Sukuk represent direct funding for companies in general via the capital
market.
According to Sharia’ah Law it is forbidden to use conventional bonds as a source of financing.
In Islam bond is a financial instrument which fits riba definition perfectly. It essentially
represents earning money on money. When trading in the capital market, the price of sukuk is
based mainly on the price of the underlying assets and its volatility, however, the price of a
bond is based mainly on the creditworthiness of the issuer.
Before sukuk are issued they have to be Sharia’ah compliant meaning that the raised funds must
be used for halal activities. The contract has to be transparent and all the specifications of it
must be clear to all investors. There is no fix return guaranteed and the underlying asset has to
generate revenue so that the investors could obtain income.
Then a special purpose vehicle (SPV) is established. This SPV is usually a subsidiary company
with legal status so that the obligations are not dependant on the parent company, therefore
secured. The SPV has a limited operational framework and its task is mainly acquisition of
assets and issuance of sukuk.
There are two types of sukuk:
 Asset-backed sukuk where the primary source of investment return is a revenue (or cash
flow) generating Sharia’ah compliant asset. The funding costs are based on the strenght
of the cash flow. In this case, the investors are owners of an asset which generates
revenues, therefore cash flow, for a company and therefore for them,
 Asset-based sukuk where investment returns are not based on revenues of a specified
asset but sukuk is only backed by Sharia’ah compliant assets of a company, more
specifically by their capital value. Compared with the conventional bonds, investors
here are actually the owners of these underlying assets. Investment returns are not
financed directly by a certain asset. The funding costs are more market driven depending
on the creditworthiness (rating) of the issuer.

Table 2.3.1 Differences between Sukuk, Conventional Bonds, and Company Shares.
Sukuk Bonds Shares
Nature Not a debt of issuer but
undivided ownership share
in specific
assets/projects/services.
Debt of issuer. Ownership share in
a corporation.
Asset-backed A minimum of 51 percent
tangible assets (or their
contracts) are required to
back issuance of sukuk al-
ijarah.
Generally not
required.
Not required.
Claims Ownership claims on the
specific underlying
assets/projects/services
and so on.
Creditors claim on
the borrowing
entity, and in some
cases liens on
assets.
Ownership claims
on the company.
Security Secured by ownership
rights in the underlying
assets or projects in
addition to any additional
collateral enhacements
structured.
Generaly
unsecured
debentures except
in cases such as
first mortgage
bonds, equipment
trust certificates,
and so on.
Unsecured.
Principal and
return
Not guaranteed by issuer. Guaranteed by
issuer.
Not guaranteed by
company.
Purpose Must by issued only for
Islamically permissible
(halal) purposes.
Can be issued for
any purposes.
Can be offered for
any purposes.
Trading of security Sale of and ownership
interest in a specific
asset/project/service and
so on.
Sale of a debt
instrument.
Sale of shares in a
company.
Responsibility of
holders
Responsibility for defined
duties relating to the
underlying
assets/projects/transactions
limited to the extent of
participation in the issue
Bondholders have
no responsibility
for the
circumstances of
the issuer.
Responsibility for
the affairs of the
company limited to
the extent of
holdings in the
company.
Source: (Abduh & Raditya Omar, 2013, p. 80)

Sukuk al-Ijarah is the most commonly used form of sukuk so its functioning is going to be
explained. When a company wants to issue sukuk, the Special Purpose Vehicle (SPV) is
established. The SPV is responsible for issuing sukuk, paying distribution amounts and the
dissolution amount. Investors then pay the principal amount for sukuk and the SPV creates a
trust over the funding which it obtained. Then acting as a trustee on behalf of the investors, the
SPV enters into a sale and purchase agreement with the originator of sukuk. Then the SPV
purchases an asset from the originator for the principal amounts obtained from investors and
leases it back to the originator in the form of ijarah for the period that matches the maturity of
sukuk. Rental payments mady by the originator are equal to the distribution amounts meaning
they are redistrubuted by the SPV between investors. At the end, the originator pays the exercise
price to the SPV which equals the dissolution amounts needed to terminate this contract. In the
case of default the SPV sells back the purchased asset and the originator must pay a higher
exercise price that includes accrued distribution amounts owed to investors.
2.4 Takaful
Takaful is an Arabic word meaning guaranteeing each other or joint guarantee. The main core
of the Takaful system – the aspect that makes it free from uncertainty and gambling is Tabarru’,
which means donation, gift, or contribution. The objective of Takaful is to pay a defined loss
from a defined fund. (Kettel, 2011, p. 128)
Takaful represents a form of islamic insurance which is Shari‘ah compliant. Muslim jurists
have always had a problem with conventional insurance because it contains riba, maysir and
gharar. There is uncertainty about the future amount that will be paid, then in addition if no
insured event occurs in the future, the insurance company may keep the premiums paid by the
policyholder. Riba is in life insurance products where policyholders recieve income from
investment that includes for example obligations.
Takaful is based on sincere solidarity. It expects its participants to donate their money to support
other participants. In this insurance scheme every participant contributes to a fund that later
covers their claims. If an individual wants to use takaful, the amounts that he or she will pay is
defined by the expected claim in the future.

The Tabarru‘ core of takaful is actually an agreement by a participant to give up a part of his
or her contributions to the mutual fund in order to fulfill his or her obligation of helping other
takaful participants when an insured event takes place. Based on shared responsibility and
cooperation between all participants, Shari‘ah approves takaful as an insurance.
A takaful company is normally called a takaful operator. There are normally two funds managed
by a Takaful operator. One is an investment fund managed as a mudaraba (profit sharing). The
other one is managed according to the principles of tabarru‘, in other words treated as a charity.
Table 2.4.1 Key differences between takaful and conventional insurance.
Takaful Conventional insurance
Takaful is based on cooperation and is void
of interest (riba) and other prohibitions.
Conventional insurance includes interest,
uncertainty (gharar) and other prohibions.
The presence of a legal control authority
(Sharia’a board) to ensure that all the
activities are done according to Sharia’a and
void of any prohibitions.
The presence of a technical commitee only.
The original premium payment goes back to
the insured after deducting its share of the
indemnities and expenses.
Neither the original premium nor any part of
it goes back to the insured.
The profits of investing premiums belong to
the insured after deducting the operator’s
share as a Mudarib.
The profits of investing premiums and assets
belong to the commercial insurance
company only.
The operator aims mainly at achieving
cooperation among community members
and developing the Ummah (the nation of
Islam)
The company aims at achieving the highest
profit possible for its owners.
The operator’s profits are the result of
investing its money, its share as a Mudarib
and the fees for running insurance
operations.
The company’s profits are the result of
investing its money in addition to the
commercial profits resulting from the entire
insurance operations.
The operator has a fixed capital that belongs
to the participants and ‚variable‘ capital that
belongs to the policyholders.
The company has one source of capital that
belongs to the commercial company only.
Source: (Kettel, 2011, p. 131)

Takaful is presented here because it is a common islamic financial service also provided by the
islamic banks. For example one of the leading islamic banks in the world Bank Islam Malaysia
offers takaful in its personal banking services7
.
2.5 Zakat
Zakat is the Islamic concept of tithing and alms. It is an obligation on Muslims to pay 2.5% of
their wealth to specified categories in society, when their annual wealth exceeds a minimum
level (nisab). Zakat is one of the Five Pillars of Islam. (Kettell, 2011, p. 82)
The word zakat means ‘purification’ and ‘growth’. The possesions of an individual are purified
by donating a part of his or her wealth to those in need. The existence of zakat is explained as
a way of cutting down imbalances and encouraging growth.
Zakat can be recieved by poor people, homeless people, zakat collectors, people who are close
to becoming Muslims. Then by people who are freeing slaves or heavily indebted people and
by travellers who find themselves in difficult situations. Zakat can be also donated to islamic
schools, hospitals, mosques and to charity.
When a certain Islamic state does not collect and distribute zakat, then Islamic bank is
responsible for establishing a zakat fund or zakat accounts for its clients and distributing it
according to Shari’ah.
2.6 Current and Saving Accounts
To offer services to ordinary people who do not need financing but need to deposit their money,
Islamic banks may use wadiah, which means safekeeping or custody. In this agreement an
individual can deposit cash or other assets in Islamic bank with a guarantee of safety. The client
can withdraw money anytime he or she wants. It is possible, and it is a common practice, that
Islamic bank charges a fee for the safekeeping but on the other hand Islamic bank can also pay
hibah (gift).
7
Personal Banking. Bank Islam Malaysia Berhad [online]. [cit. 2014-05-03]. Dostupné z
:http://www.bankislam.com.my/en/Pages/PersonalBanking.aspx

Islamic bank can also use qard which is essentially an interest-free loan. The current account
of a client, for example, works as a loan to the bank. Qard is due to pay immediately when
requested8
.
Islamic banks provide debit and credit cards for a fee. When credit card is issued there is always
a fixed limit to which a client can borrow money. If credit is provided, a fixed fee is set for the
client for borrowing money. Both fee and borrowed money have to be repaid back.
However the most used scheme used in Islamic finance is two-tier mudaraba. As mentioned
before, clients provide the Islamic banks with funds via unrestricted mudaraba.
To sum up the information above, in mudaraba clients are rewarded because they provided
Islamic bank with funds needed for the bank’s investment activities. However in the case of
wadiah or quard, the depositors share profit with the bank and it is Islamic bank’s will if they
will recieve hibah.
8
Current Account. Islamic Bank of Britain [online]. 2013 [cit. 2014-04-24]. Dostupné z: http://www.islamic-
bank.com/current-account/

3 Comparison of growth of islamic and conventional banking in
the example of Malaysia
3.1 Introduction of practical example
In this last section a closer look is going to be taken at a country which is trying to become a
global leader in Islamic finance and that country is Malaysia. This part aims to describe the
Islamic banking in practical way applied in the real economy. Malaysia is the example of a
country that has been developing the Islamic financial industry for almost four decades.
Nowadays its Islamic financial sector is fully integrated into Malaysian legal system, regulatory
framework and into the overall Malaysian financial sector.
History of Islamic finance in Malaysia will be presented, its foundation in 20th
century and the
development and growth to modern days. After that providing an analysis of the biggest banks
in Malaysia in order to answer two questions. Is the Islamic banking in Malaysia really growing
more rapidly then the conventional banking? If so, what could be probable causes of that
success?
3.2 Malaysian Islamic financial sector
Malaysia is a multinational and multireligious country with a Muslim Malay majority and two
main minorities, Chinese and Indian. Altough the Malays make up the majority in Kuala
Lumpur and nation wide as well, the Chinese were the ones who were driving the economic
growth and industrialization of Malaysia. Ethnic protests took place in late sixties when Muslim
majority wanted to gain more power over the Chinese who were controlling the commercial
sector.
In 1983 the Malaysian government decided to uprise its Muslim majority by setting up
foundations fot the Islamic financial sector via the Islamic Banking Act (IBA) that enabled
Bank Negara Malaysia (Central Bank of Malaysia) to regulate and supervise Islamic banks.
Bank Islam Malaysia Berhad was established the same year as a pioneer Islamic bank in
Malaysia, from that moment creating a dual banking sector. Government Investment
Certificates (GIC) were issued the same year under the Shari’ah principles as liquid investment
tools for Islamic banks. The purpose of GIC was to enable Islamic banks to meet regulatory
requirments for liquidity.

In 1996 banks licensed under the Banking and Financial institutions Act (BAFIA), which was
enacted in 1989, were allowed to establish new Islamic banking business.
In 1997 Bank Negara Malaysia established the National Shari’ah Advisory Council (NSAC) to
harmonise Sharia’ah principles used by banks. The NSAC operates as the highest Shari’ah
authority in Malaysia overseeing Islamic finance (islamic banking and takaful). The NSAC also
evaluates new products that Malaysian Islamic banks invent. In the year of 2004 Bank Negara
Malaysia enacted a policy on takaful forcing Islamic banks to offer it as a first choice protection
for its customers.
Malaysia has one of the most developed Islamic financial systems in the world as the Islamic
debt securities market, the Islamic equity market and the Islamic Interbank Money Market were
established between 1990 and 1995. There are objections concerning the trading of debt
securities between Muslim countries such as those in need of financing should know their
creditors. However, according to Maliki scholars, which have been shaping the islamic finance
in Malaysia, debt securities trading is possible as long as the debtors know their debts will be
traded.
On 30 June 2013 the Islamic Financial Service Act was enacted to further strenghten and
establish a proper end-to-end Shari’ah regulatory framework which had not been provided
before. The legislation specifically provides for the enforcement of Shariah non-compliance
risk and imposes statutory duty upon the Islamic financial institutions to ensure that their aims,
operations, affairs, businesses and activities are in compliance with Shariah rules. (Selangor,
2013)

3.3 Comparison of asset growth and profitability
The Islamic banking is known for its dynamic growth. The Islamic assets were set to cross 1.7
trillion US dollars in 2013 with 17.6% annual average growth between 2009 and 2012.
Malaysian Islamic assets grew by average 20% in that period. However, the return on equity
(ROE) in Islamic banks is overall lower than the ROE of their conventional competitors9
.
3.3.1 Asset growth comparison
In this section, the asset growth between conventional and Islamic banks will be compared in
2012 and 2011 in order to discuss if the Malaysian Islamic banks have been really growing
faster than the Malaysian conventional banks.
The following charts are showing total assets of selected Islamic banks in Malaysia in thousands
of Malaysian Ringgit. Selected Islamic banks are Bank Islam Malaysia Berhad, Maybank
Islamic Berhad, HSBC Amanah Malaysia Berhad, Kuwait Finance House (Malaysia) Berhad,
RHB Islamic Bank Berhad, Hong Leong Islamic Bank Berhad, Alliance Islamic Bank Berhad,
CIMB Islamic Bank Berhad and Bank Muamalat Malaysia Berhad.
Chart 3.3.1.1 Islamic banks – total assets in 2011 and 2012
9
World Islamic Banking Competitiveness Report 2013-2014: The transition begins. In: Ernst & Young [online].
2013 [cit. 2014-05-17]. Available at: http://www.ey.com/Publication/vwLUAssets/EY_-
_World_Islamic_Banking_Competitiveness_Report_2013%E2%80%9314/$File/EY-World-Islamic-Banking-
Competitiveness-Report-2013-14.pdf
RM32226504
RM43102785
RM6223100
RM22650317
RM12178617
RM10122166
RM10442833
RM75512938
RM18315209
RM37450798
RM51225040
RM6508221
RM25609662
RM21902469
RM9096691
RM12146179
RM91432370
RM20495378
Bank Islam
Malaysia
Berhad
CIMB
Islamic Bank
Berhad
Alliance
Islamic Bank
Berhad
RHB Islamic
Bank Berhad
Hong Leong
Islamic Bank
Berhad
Kuwait
Finance
House
(Malaysia)
Berhad
HSBC
Amanah
Malaysia
Berhad
Maybank
Islamic
Berhad
Bank
Muamalat
Malaysia
Berhad
TOTAL ASSETS IN 2011 AND 2012
Total Assets 2011 Total Assets 2012
Source: Statements of financial position. Own elaboration.

The analysis of asset size is based on data of financial positions according to IFRS. Islamic
banks were selected according to availability of their financial results and according to their
importance based on asset size and market capitalization10
(asset size and market capitalization
of financial groups of which the Islamic banks are often subsidiaries). Most of them are a part
of financial groups which also own conventional banks in Malaysia.
The rate of growth of assets of selected Islamic banks is showed below.
Chart 3.3.1.2 Islamic banks – asset growth 2011-2012
The analysis of the rate of growth of assets is based on data of financial positions according to
IFRS. The Islamic banks were selected according to availability of their financial results and
according to their importance based on asset size and market capitalization11
(asset size and
market capitalization of financial groups of which the Islamic banks are often subsidiaries).
Most of them are a part of financial groups which also own conventional banks in Malaysia.
10
Top Banks in Malaysia. Online Bank Watch [online]. 2012 [cit. 2014-05-05]. Available
at: http://www.onlinebankwatch.com/malaysia/top-banks-in-malaysia.html
11
16,21% 18,84%
4,58% 13,07%
79,84%
-10,13%
16,31% 21,08%
11,90%
Bank Islam
Malaysia
Berhad
CIMB
Islamic
Bank
Berhad
Alliance
Islamic
Bank
Berhad
RHB Islamic
Bank
Berhad
Hong Leong
Islamic
Bank
Berhad
Kuwait
Finance
House
(Malaysia)
Berhad
HSBC
Amanah
Malaysia
Berhad
Maybank
Islamic
Berhad
Bank
Muamalat
Malaysia
Berhad
ASSET GROWTH 2011-2012

The annual average growth based on this selected data was 19,08% during the year 2012. Most
of the Islamic banks expanded around this growing rate except of Alliance Islamic Bank which
expanded by 4,58% and Hong Leong Islamic Bank which grew by almost 80%. Only Kuwait
Finance House’s assets shrank by 10,13%.
The following charts are showing total assets of selected conventional banks in Malaysia in
thousands of Malaysian Ringgit. Conventional banks were selected according to the same
criterias as Islamic banks were. Selected conventional banks are CIMB Bank Berhad, RHB
Bank Berhad, Alliance Bank Malaysia Berhad, Hong Leong Bank Berhad, HSBC Bank
Malaysia Berhad, Public Bank Berhad, Maybank Berhad, AFFIN Bank Berhad and AmBank
Berhad.
Chart 3.3.1.3 Conventional banks – total assets in 2011 and 2012
RM186722227
RM120731463
RM29380878
RM87650089
RM206768918
RM73756417
RM323999608
RM40070290
RM80495362
RM206795324
RM144661155
RM32772856
RM140284562
RM228575968
RM66956263
RM342556673
RM41676054
RM84064621
CIMB Bank
Berhad
RHB Bank
Berhad
Alliance
Bank
Malaysia
Berhad
Hong Leong
Bank Berhad
Public Bank
Berhad
HSBC Bank
Malaysia
Berhad
Maybank
Berhad
AFFIN Bank
Berhad
AmBank
Berhad
TOTAL ASSETS IN 2011 AND 2012
Total Assets 2011 Total Assets 2012

The analysis of asset size is based on data of financial positions according to IFRS.
Conventional banks were selected according to availability of their financial results and
(asset size and
market capitalization of financial groups of which conventional banks are subsidiaries).
The rate of growth of assets of selected Islamic banks is showed below.
Chart 3.3.1.4 Conventional banks – asset growth 2011-2012
12
10,75%
19,82%
11,54%
60,05%
10,55%
-9,22%
5,73% 4,01% 4,43%
CIMB Bank
Berhad
RHB Bank
Berhad
Alliance
Bank
Malaysia
Berhad
Hong Leong
Bank
Berhad
Public Bank
Berhad
HSBC Bank
Malaysia
Berhad
Maybank
Berhad
AFFIN Bank
Berhad
AmBank
Berhad
ASSET GROWTH 2011-2012

The analysis of the rate of growth of assets is based on data of financial positions according to
IFRS. Conventional banks were selected according to availability of their financial results and
(asset size and
market capitalization of financial groups of which the Islamic banks are often subsidiaries).
The annual average growth based on this selected data was 13,07% during the year 2012. Four
banks expanded around this growing rate. Maybank, which is the largest bank in Malaysia, saw
the asset growth at 5,73% and two other banks grew similary around 4%. Hong Leong Bank
Berhad is again by far the most growing according to assets, the bank expanded by 60,05%. On
the other hand HSBC Bank Malaysia asset size shrank by 9,22%.
The rates of asset expansion are shown below.
Charts 3.3.1.5 Comparison of asset growth
This analysis shows that the Islamic banking sector’s asset size grew 6,01% more than the asset
size of conventional banking sector.
13
19,08%
13,07%
Annual Average Growth 2011-2012 Islamic
banks
Annual Average Growth 2011-2012
Conventional banks
COMPARISON OF ASSET GROWTH

3.3.2 Profitability comparison
In this section, the profitability of conventional and Islamic banks will be compared in 2012
and 2011 in order to discuss if Malaysian Islamic banks had lower ratio of return on equity
(ROE) than conventional banks in Malaysia did.
Return on equity (ROE) is the amount of net income returned as a percentage of shareholders
equity. Return on equity measures a corporation's profitability by revealing how much profit a
company generates with the money shareholders have invested. (Investopedia, 2014)
ROE = Net Income / Shareholder’s Equity. (Investopedia, 2014)
Return on equity of selected Islamic banks is presented below.
Chart 3.3.2.1 Islamic banks – ROE in 2011 and 2012
Ratios of ROE were analysed based on the data of same Islamic banks that were used in the
asset comparison section. Maybank Islamic Berhad is excluded from this analysis because the
net income for the year 2011 was only from 1.7.2011 to 31.12.2011.
13,44%
17,36%
11,99% 11,39%
7,79%
-31,46%
11,19% 9,84%
13,90%
17,11%
13,28%
9,20%
12,63%
4,21%
12,81%
5,90%
Bank Islam
Malaysia
Berhad
CIMB Islamic
Bank Berhad
Alliance
Islamic Bank
Berhad
RHB Islamic
Bank Berhad
Hong Leong
Islamic Bank
Berhad
Kuwait
Finance
House
(Malaysia)
Berhad
HSBC
Amanah
Malaysia
Berhad
Bank
Muamalat
Malaysia
Berhad
RETURN ON EQUITY IN 2011 AND 2012
ROE 2011 ROE 2012
Source: Statements of financial position and statements of income. Own elaboration.

Return on equity of selected conventional banks is presented below.
Chart 3.3.2.2 Conventional banks – ROE in 2011 and 2012
Ratios of ROE were analysed based on the data of same conventional banks that were used in
the asset comparison section. Maybank Berhad is excluded to give a fair comparison based on
8 subjects.
15,61%
15,87%
12,68%
12,30%
23,47%
19,48%
11,59%
20,21%
13,64%
14,90%
13,37%
12,35%
21,94%
19,38%
11,87%
20,13%
CIMB Bank
Berhad
RHB Bank
Berhad
Alliance Bank
Malaysia
Berhad
Hong Leong
Bank Berhad
Public Bank
Berhad
HSBC Bank
Malaysia
Berhad
AFFIN Bank
Berhad
AmBank
Berhad
RETURN ON EQUITY IN 2011 AND 2012
ROE 2011 ROE 2012
Source: Statements of financial position and statements of income. Own elaboration.

The last chart is directly comparing ROE in 2011 and 2012 between Islamic and conventional
banks in Malaysia.
Chart 3.3.2.3 ROE comparison
Average annual ratios of ROE were counted with the arithmetic average technique. Data were
used from the statements of financial position and statements of income according to IFRS of
both Isalmic and conventional banks.
Return on equity in the Malaysian Islamic banking sector is lower than than ROE of
conventional banks. According to this analysis, ROE in 2011 was only 6,44%. This extremely
low number is biased by the selected data when Kuwait Finance House (Malaysia) Berhad
suffered losses and its ROE was negative.
2011; 6,44%
2012; 11,13%
2011; 16,40% 2012; 15,95%
1 2
ROE COMPARISON
ROE of selected Islamic banks ROE of selected conventional banks
Source: Statements of financial position and statements of income. Own
elaboration.

3.3.3 Analysis summary
This analysis confirmed that the Islamic banks are really growing more rapidly than the
conventional banks but the ROE is lower. The pace of growth of Islamic banking is globally
slowing from rates around 20% but Malaysia was able to maintain high asset growth
performance between 18% to 20% due to long-term developmnet of its Islamic financial
sector14
. Weaker results in profitability could be explained by the architecture of the system.
There is no compound interest that generates profits and higher costs can be caused by profit
loss sharing.
Building the sector for more than 30 years, Malaysia’s goal is to have a rich and stable financial
system. The success of the Islamic banking in Malaysia consists of relentless product
innovation, innovative Islamic investment products, wide range of domestic and foreign Islamic
financial institutions and adoption of modern regulatory frameworks such as Basel III together
with Shari’ah practices. Bank Negara Malaysia recognized the current importance of human
capital so the International Center for Education in Islamic Finance (INCEIF) was set up by
BNM in 2006 in order to strenghten the system and educate and train future leaders and decision
makers of Islamic finance. There is also the Malaysia Islamic Financial Center (MIFC)
Community founded in 2006. The MIFC Community is a network of regulators such as BNM,
Securities Comission Malaysia, Bursa Malaysia, government agencies and takaful and re-
takaful companies15
.
Malaysia is one of the best examples that diverse and visionary driven financial sector is the
key to a stable economy from that should benefit all. Long-term building, innovation,
standardization and liberalisation of the Islamic banking is positioning Malaysia as the Islamic
Finance hub and if Malaysia does not succeed as a global Islamic Finance leader, it will
definitely play the key role at least in the South Asian region.
14
World Islamic Banking Competitiveness Report 2013-2014: The transition begins. In: Ernst & Young [online].
2013 [cit. 2014-05-17]. Available at: http://www.ey.com/Publication/vwLUAssets/EY_-
_World_Islamic_Banking_Competitiveness_Report_2013%E2%80%9314/$File/EY-World-Islamic-Banking-
Competitiveness-Report-2013-14.pdf
15
BNM Malaysian Financial Sector. Bank Negara Malaysia Central Bank of Malaysia [online]. [cit. 2014-05-
14]. Dostupné z:http://www.bnm.gov.my/index.php?ch=fs_mfs&pg=fs_mfs_bank

The Islamic banking will play a global role in the financial industry because the conventional
financial system favors speculation and it has been failing to deliver financing to entrepreneurs
and companies (multinational companies excluded) which are the drivers of the real economy
and innovation. Another key factor in favor of the Islamic banking is relatively low penetration
of the markets that has already introduced it and then huge potentional markets such as India,
former Soviet countries around the Caspian Sea and Europe. Europe is not potentionally only a
big market from the perspective of a Muslim population mainly in the UK, France, Germany
and Italy but also from the perspective and as a form of ethical banking (known as Socially
Responsible Investing) which is becoming stronger, more visible a more needed than ever.

Conclusion
The goal of this bachelor thesis was to introduce the Islamic banking as a new alternative model
in comparison to conventional financial industry, decribe historical and religious background
of Islam and financing techniques used in Islamic finance. Based on an interest-free scheme
and limited speculation, the Islamic banking has Shari’ah law and Islamic ethical principles in
its core. The main mission of the Islamic banking is to serve the real economy, not to master it,
on the basis of cooperation (profit loss sharing) to eliminate poverty and inequality. Generating
profit for shareholders is not the main idea of this system.
The aim of the first chapter was to describe historical roots of Islam followed by the
development of modern Islamic banking. From the formation of Islam in the 7th
century to the
modern era, especially 20th
century, that saw decolonisation which made the foundation of the
Islamic banking possible. The establisment of the Islamic Development bank was described as
an important step in the internationalization of Islamic finance while other important institutions
were created later, such as the Accounting and Auditing Organization for Islamic Institutions,
in order to ensure standartization and integrated cooperation between Muslim countries. The
second part of the chapter introduced Islamic religious principles, mainly Shari’ah law, that
have a vital influence on the the Islamic banking scheme and daily practices. The focus was set
on describing the difference between halal and haram activites, then the Islamic prohibitions
were described such as gharar (uncertainty), maysir (gambling) and the most important one,
riba (interest).
Financing techniques used in Islamic finance were described in the second chapter. The
financing techniques were divided into two groups and all of the the financing techniques are
types of contracts. First group were profit loss sharing techniques represented by mudaraba and
mushraka. Mudaraba is purely profit sharing technique where capital is provided for an agreed
fee. Two-tier mudaraba was presented as a modern way of financing developed by the Islamic
banks so that the funds can be transferred with the Islamic bank as an intermediary. While
musharaka is the profit loss sharing technique. In both cases the fees, paid for the provided
capital, are relative shares of profit. Second group are profit mark-up techniques represented by
murabaha, istisna, ijarah and salam. All of these financing techniques are contracts of sale with
the exception of ijarah. Ijarah is a lease contract very similar to conventional leasing that can
be used as a base for sukuk. Sukuk was then described as an Islamic bond, generally and on the
example of sukuk al-Ijarah.

Comparison of sukuk, conventional bonds and shares was provided. Takaful, Islamic insurance,
was also presented as an important part of Islamic finance and a technique used by Islamic
banks. There was also a description of zakat and techniques used for the management of
deposits.
The main goal of the last chapter was to provide comparison between the Islamic and
conventional banking in Malaysia on the example of selected banks and its asset growth and
profitability. Also to introduce the form and development of the Islamic banking in a pioneering
country that is trying to become a global leader in the Islamic finance. The development is
described chronologically from the year of 1983 to the 21st
century. Malaysian current dual
financial sector regulated by Bank Negara Malaysia (Central Bank of Malaysia) was presented
as well as standardization and regulation of the Islamic financial products provided by the
National Shari’ah Advisory Council which was established by Bank Negara Malaysia. The
results of the analysis were discussed with the Islamic banking showing higher asset growth in
the Malaysian financial sector while the profitability, presented by the return on equity, was
lower than the profitability of conventional banks. Own explanations of the analysis were
provided discussing mainly the gradual institutional development and government support as
main drivers of the success of the Islamic banking in Malaysia.

4 Bibliography
5 Annex
Tables of auxiliary calculations for the Asset comparison.

Bachelor Thesis - Islamic Banking

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