ISLAMIC

F INANCE TODAY
The pulse of ethical business October 2020

PITFALLS OF
DUAL BANKING SYSTEM Hazik Mohamed

Professor Saiful Azhar Rosly

A Panacea for Social ills Riza Yehiya

The Power of Zakat Magda Ismail

ISSN 1800-1319

Riba (Interest) Syammon Jaffar

Musharaka Mutanaqisa Abdulazeem Abozaid

Lessons for Entrepreneurs Ethica Finance

MIT Global Media and Publications

 INSIDE
PITFALLS OF DUAL-BANKING ZAKAT
IFT 4 The Unbreakable Future
Prof. Saiful Azhar Rosly
IFT 10 Panacea for Social ills
Riza Yehiya

THE POWER OF ZAKAT RIBA (INTEREST)

IFT 14 In Empowering Society
Magda Ismail
IFT 18 From an Economic Viewpoint
Syammon Jaffar

MUSHĀRAKA MUTANĀQISA ISLAMIC FINANCE

IFT 22 A Proposed Formula
Abdulazeem Abozaid
IFT 28 Lessons for Entrepreneurs
Ethica Institute
PITFALLS OF THE DUAL-BANKING SYSTEM:
THE UNBREAKABLE FUTURE OF ISLAMIC BANKING
PROFESSOR SAIFUL AZHAR ROSLY

Islamic Finance Today - October 2020 IFT 4

 Islamic banking institutions are established to provide an alternative
financing arrangement that uses trading (al-bay) as opposed to usury
in their business. The banking modality however is still based on the
deposit-taking function where deposit funds are used by banks to make
loans. Deposit funds are in essence loans acquired from depositors who
can make withdrawal on call, thus bank faces withdrawal risk and also
potential bank run under economic shocks.

While Islamic banks may label the deposits with various Islamic
contracts such as mudarabah, wadiah or tawaruq as long as these funds
are deposit in nature, they remain a loan the bank takes from depositors,
hence subjected to prudential regulation of the Basel Committee of
Banking Supervision (BCBS).

The implication can be severe as potential loss from loans are only
carried by banks and not the depositors. Banks are required to make
impairment provisions to absorb potential loss from loans which can
diminish earnings from large defaults. They also must hold enough
capital to support the loans against unexpected losses arising from
systematic risks. In a way, Islamic banks can pursue to increase earnings
either by way of making more loans or taking more risks. In the latter,
taking greater risks, say giving out unsecured loans will allow banks to
charge higher profit rate.

But doing will also require the banks to hold more capital to support
the risky exposures. Hence, risk-taking behaviour is much controlled
by regulatory capital requirement. For this reason, it is highly unlikely
for Islamic banks to venture into real sector production typical to the
Quranic commandment of al-bay, as they have to hold high regulatory
capital against these risky ventures.

Downside of Dual Banking System

Much of the above problems are associated with establishing Islamic banks
in a dual-banking framework. Little did our Islamic banking founding
fathers know that setting up an Islamic bank within a conventional
infrastructure has opened it to inherit ills of the conventional system. It
will also make it harder for Islamic banks to realize its social goals and
to positively contribute to a stable and equitable economy

a) Deposit-taking bank: Islamic banks that take deposits to make

murabahas as mentioned earlier will be restricted from using real-sector
contracts under the pretext of istisna, salam, mudaraba, real sale and
lease as deposits are risk-free

Islamic Finance Today - October 2020 IFT 5

 funds, hence risks in loans must be carried by the bank which it later
shifted to borrowers. On the other hand, banks make loans only to credit
worthy borrowers using the low yielding deposit funds supplied by
the working class, hence enlarging income disparity between the two
groups. The fact that depositors are not risk-takers will frustrate efforts
to use deposit funds to finance less credit worthy customers such as those
in the microfinance business, hence the un-bankable group will get no
access to banking facilities which can further widen income disparities.

b) Fractional reserve banking (FRB): Islamic banks are established

within the fractional reserve banking system that is proven to be
responsible for asset bubbles making the financial system increasingly
fragile. The FRB allows money creation by commercial banks which
when going out of control will lead to excessive money supply and
runaway inflation. Banks, including Islamic banks are required to fulfil
the statutory reserve requirement (SRR) while excess reserves are used
to make loans, which becomes new deposits and money supply. Given
SRR = 5 percent which gives a credit multiplier of 20, $1 trillion of
money printed by government is able to create up to $20 trillion new
money supply with $19 trillion created by commercial banks.

c) Fiat money: Transactions in Islamic banking are facilitated via the fiat
money system where currency is issued without any backing of gold. This
will make it relatively easy for governments to print money which forms
the monetary base essential for initiating deposit creation. This further
contributes to fragility from the inherent booms and busts of economies.
In the days of the Mamluk Sultanate in the 14th century A.D., the use of
fulus or copper coins as opposed to gold dinar as money, have produced
human suffering from the hyperinflation it created arising from plentiful
supply of cheap copper imported from Italy and neighbouring areas
which was turned into fulus by the sultanate. Al-Maqrizi then proposed
the use of gold dinar as the remedy to the hyperinflation and it worked.

d) Commercial banking: As a commercial bank, an Islamic bank puts

paramount importance to its profitability objectives. Its fiduciary duties
to shareholders and depositors warrant banks to operate efficiently so that
profit can be maximized and costs minimized. They not made to achieve
social goals such as making qard hasan loans to the poor or nurturing new
start-ups. Development role of commercial bank is not a given mandate
from the shareholders. Some have advocated the Maqasid Shariah as the
basis of establishing an Islamic bank with a social mandate. Little did
they understand about the pitfalls of the dual-banking much responsible
for the lack of social purpose in Islamic banks today

Islamic Finance Today - October 2020 IFT 6

 e) Basel Regulation: As Islamic banks use depositors’ money to make
murabahas, control is essential to deter bank from taking excessive risks
that can endanger deposit funds. This is because banks do not use their
own money namely, capital, to make loans. Banks capital holding is
only a fraction of total deposits, so to control moral hazards is critical.
The control via prudential regulation emphasises high level principles of
sound financial and business practices, and the responsibility of the board
and senior management of banks to manage risks in line with individual
business strategies and exposures of the bank. These include minimum
capital adequacy requirements and prudential limits on excessive risk-
taking which in line with the Basel Standard (BNM 2019). While this
is good to uphold sound prudential standard, it will allow Islamic banks
with no chance to use real sector contracts as these contracts are highly
risky against which banks must hold high capital requirement.

f) Competition from larger conventional banks: Islamic banks were set up

in many ways. Early Islamic banks were mainly full-fledged banks, but
many are now subsidiaries and windows of well-established and bigger
conventional banks, hence competing with the latter can a challenging
one, if not fighting a losing battle. Conventional banks are generally
well-capitalized and larger in size, hence they have scale economies
which Islamic banks often lack. This can adversely affect earnings and
capacity to bid for larger customer base. Business and risk strategies will
be limited to a few saturated markets as they are not able to leverage on
the many Islamic real sector contracts available. For this reason, pricing
follows interest rate of conventional banks as most Islamic products are
based of debt with credit risk posing as the major risks of banks.

Deposit-
taking Model

Fractional
Conventional
reserve
Banking
banking

ISLAMIC
BANKING
Basel
Regulation Fiat money

Commercial
banking
model

Islamic Finance Today - October 2020 IFT 7

 Doing Islamic banking business within a dual-system has been a
tough road for too long when banks are expected to perform beyond
profitability which they cannot. Some have criticized Islamic banks as
being materialistic and mundane in their business objectives as profits
have become their only concern. Such a gross misunderstanding of Islam
must be corrected as the main of objective of business is to earn profit.

The Way Forward

A promising way forward is evident in the Malaysian experiment of

the Investment Account Fund (IAF) in 2013. Islamic banks are now
required to segregate deposit funds from the investment account funds
(IAF), as the latter is now a purely equity product. Gone were the days
where mudaraba contract was applied to a deposit product where mixing
both can expose Islamic banks to Shariah non-compliance risk (SNCR).
Establishing IAF is like setting a limited purpose bank within a bank but
even better since no new overheads are required.

As an equity fund, IAF will absorb risks of real sector venture and
investments, hence Islamic bank can benefit from considerable capital
savings. Unlike mutual funds, IAF can be invested in ventures, hence
opening up SMEs to possible partnership with the fund. Here are some
possible benefits of IAF which can open new avenues for greater and
wholesome performance of Islamic banks operating within the dual-
banking system:

1. Improve income distribution: higher returns from IAF relative to

deposits will increase income of customers. In Malaysia, average
returns from IAF is consistently around 6-7% per annum compared with
tawarruq and interest bearing fixed deposit at around 2%

Islamic Finance Today - October 2020 IFT 8

 2. Reducing contract concentration risk: the intensified use of tawarruq
opens the bank to SNCR when desperate defaulters may use Shariah as a
defence against bankruptcies. IAF can open the application of real sector
contracts as risks are now carried by IAF holders, thus diversification is
now possible.

3. Stimulate real sector financing offerings: since the bank will not carry
risks of ventures, IAF should be able to finance SME ventures tailor-
made to the risk appetite of corresponding IAF holders. This will help
increase employment, income and purchasing power of people and the
GDP as well.

4. Increase fee-based income of Islamic banks: This will further improve

performance of Islamic banks, hence to be less reliant on operating
profits. Expertise of banking will transcend beyond credit appraisal and
debt collection and move into venture financing and asset management.

5. Pacify the fractional reserve banking which is responsible for

uncontrolled money creation and fragility: as more people are attracted
to IAF, more fixed depositors and equity investors may move to IAF
market. Eventually deposits will be used for transaction purposes like
the e-wallet system with less deposits now being used to make loans and
murabahas. This reduces deposit creation and fragility as well.

However, all is meaningless if Islamic banks see IAF as a distractor and

disruptor of the status quo, which is tawarruq. The off-balance sheet
factor may deter banks from IAF but to be impactful and therefore
a worthy alternative to riba, Islamic banks via IAF should be able to
champion all expectations - profit, ethical and social.

Islamic Finance Today - October 2020 IFT 9

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