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251 Regulation and Performance of Islamic Banking in Bangladesh Abu Umar Faruq Ahmad M. Kabir Hassan Executive Summary This article examines current legal and regulatory issues of Islamic banking in Bangladesh. The most important issue in this context is the lack of a well-defined reg- ulatory and supervisory framework for Islamic banks for their effective functioning in line with the tenets of Shariah. Other major issues come from the absence of an interbank Islamic money market, following the same policy and guidelines for Islamic and conventional banking by the Bangladesh Bank, presence of a discriminatory legal reserve requirement for Islamic and conventional banking, prevalence of a restrictive environment in the capital market, and the lack of legal support and protection of Bangladesh Bank to avoid the associated risks of Islamic banks. For this purpose, it is suggested that Islamic banks in Bangladesh should have an independent banking act that controls, guides, and supervises their functions and provide legal support to the parties concerned. © 2007 Wiley Periodicals, Inc. Abu Umar Faruq Ahmad is an independent Islamic legal advisor with research interests in the devel- opment of Shariah-compatible products and instruments. He received an LL.B. in Shariah from the Islamic University of Medina, Saudi Arabia, in 1984, and in 2003 he received an LL.M. (Honors) in law from the University of Western Sydney, where he completed his research on Islamic banking in Bangladesh. At present, he is undertaking his doctoral thesis entitled “Law and Practice of Mod- ern Islamic Finance in Australia” at the University of Western Sydney Law School with a UWS Post- graduate Research Award. Mr. Ahmad has spoken at several national and international forums, including the Sixth Harvard University Forum on Islamic Finance and the Twelfth Annual Global Finance Conference (Global Finance Conference 2005) at Trinity College Dublin where he served as the Conference Program Committee member. He has received a number of research grants to speak at these world forums on Islamic banking and finance from international organizations and the University of Western Sydney, Australia. He has been the chairman of the Shariah Advisory Board at the Islamic Co-operative Finance Australia Limited (ICFA) since its inception in 1999. Cur- rently, he is a lecturer of Islamic legal studies at Sule College, Sydney [[email protected]]. M. Kabir Hassan is a tenured professor in the Department of Economics and Finance at the Uni- versity of New Orleans, Louisiana, and currently holds a visiting research professorship at Drexel University in Philadelphia, Pennsylvania. He is editor of the Global Journal of Finance and Economics. Dr. Hassan has edited and published many books along with articles in refereed academic journals, and is coeditor (with Mervyn K. Lewis) of Islamic Finance: The International Library of Critical Writ- ings in Economics (Edward Elgar, 2006). A frequent traveler, Dr. Hassan gives lectures and work- shops in the United States and abroad, and has presented over 100 research papers at profes- sional conferences [[email protected]]. Thunderbird International Business Review, Vol. 49(2) 251–277 • March–April 2007 Published online in Wiley InterScience (www.interscience.wiley.com). © 2007 Wiley Periodicals, Inc. • DOI: 10.1002/tie.20142

Transcript of kabir hasan

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251

Regulation and Performance ofIslamic Banking in Bangladesh

Abu Umar Faruq Ahmad ■ M. Kabir Hassan

Executive Summary

This article examines current legal and regulatory issues of Islamic banking inBangladesh. The most important issue in this context is the lack of a well-defined reg-ulatory and supervisory framework for Islamic banks for their effective functioningin line with the tenets of Shariah. Other major issues come from the absence of aninterbank Islamic money market, following the same policy and guidelines for Islamicand conventional banking by the Bangladesh Bank, presence of a discriminatory legalreserve requirement for Islamic and conventional banking, prevalence of a restrictiveenvironment in the capital market, and the lack of legal support and protection ofBangladesh Bank to avoid the associated risks of Islamic banks. For this purpose, it issuggested that Islamic banks in Bangladesh should have an independent banking actthat controls, guides, and supervises their functions and provide legal support to theparties concerned. © 2007 Wiley Periodicals, Inc.

Abu Umar Faruq Ahmad is an independent Islamic legal advisor with research interests in the devel-opment of Shariah-compatible products and instruments. He received an LL.B. in Shariah from theIslamic University of Medina, Saudi Arabia, in 1984, and in 2003 he received an LL.M. (Honors)in law from the University of Western Sydney, where he completed his research on Islamic bankingin Bangladesh. At present, he is undertaking his doctoral thesis entitled “Law and Practice of Mod-ern Islamic Finance in Australia” at the University of Western Sydney Law School with a UWS Post-graduate Research Award. Mr. Ahmad has spoken at several national and international forums,including the Sixth Harvard University Forum on Islamic Finance and the Twelfth Annual GlobalFinance Conference (Global Finance Conference 2005) at Trinity College Dublin where he served asthe Conference Program Committee member. He has received a number of research grants tospeak at these world forums on Islamic banking and finance from international organizations andthe University of Western Sydney, Australia. He has been the chairman of the Shariah AdvisoryBoard at the Islamic Co-operative Finance Australia Limited (ICFA) since its inception in 1999. Cur-rently, he is a lecturer of Islamic legal studies at Sule College, Sydney [[email protected]].M. Kabir Hassan is a tenured professor in the Department of Economics and Finance at the Uni-versity of New Orleans, Louisiana, and currently holds a visiting research professorship at DrexelUniversity in Philadelphia, Pennsylvania. He is editor of the Global Journal of Finance and Economics.Dr. Hassan has edited and published many books along with articles in refereed academic journals,and is coeditor (with Mervyn K. Lewis) of Islamic Finance: The International Library of Critical Writ-ings in Economics (Edward Elgar, 2006). A frequent traveler, Dr. Hassan gives lectures and work-shops in the United States and abroad, and has presented over 100 research papers at profes-sional conferences [[email protected]].

Thunderbird International Business Review, Vol. 49(2) 251–277 • March–April 2007

Published online in Wiley InterScience (www.interscience.wiley.com).

© 2007 Wiley Periodicals, Inc. • DOI: 10.1002/tie.20142

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INTRODUCTION

Banking in the form in which it exists today is comparatively of recentorigin. Before the advent of modern banking, direct finance, wherethe owner of capital deals directly with the user of capital, was thecustomary mode of transference of funds from savers to investors.With the progress of trade and industry and increased financingrequirements of productive enterprises, direct finance proved aninadequate mechanism for such transference and banks emerged onthe scene to undertake financial intermediation between savers andinvestors. Furthermore, in modern times, they emerged as organiza-tions that engage in any or all of the various functions of banking(i.e., receiving, collecting, transferring, paying, lending, investing,dealing, exchanging, and servicing money and claims to money bothdomestically and internationally; Woelfel, 1993, p. 69). In its morespecific sense, however, the term bank refers to institutions providingdeposit facilities for the general public.

Perhaps the most striking feature in the structure of modern bank-ing and finance is the use of credit institutions of accumulatedwealth. Loans based on deposit funds provide financial support ofa wide variety of business and industrial enterprises. By means ofthis credit function, banks occupy a very important position in amodern economy. Through the process of financial intermediationbetween savers and investors, they exert immense employment andincome generation effects, which ultimately help in economicadvancement and social welfare. Another social welfare aspect ofbanks is through the provision of a return to depositors who aremainly small savers and include such weaker sections of the societyas widows, disabled orphans, and the aged who could otherwisemake no profitable use of their savings. Furthermore, the banks are“manufactories of credit” (Kniffin, 1937, p. 31) that serve thecommunity and keep the wheels of commerce and industry revolv-ing. By offering opportunities for investment and safe custody ofdeposits, they stimulate the habit of saving and discourage hoard-ing or the unproductive use of surplus wealth, thus promotinginvestment and the growth of capital. A wise banking policy maygo a long way toward mitigating the shocks of an economic crisis,while a banking system, if badly constructed or badly handled, iscapable of inflicting great harm on trade and industry and mayeven upset the whole economy.

We describe the banking system and the regulatory conditions ofIslamic banking in Bangladesh in this article. Specifically, we focus

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Perhaps themost strikingfeature in thestructure ofmodern bankingand finance isthe use of creditinstitutions ofaccumulatedwealth.

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on the shortcomings of the regulatory framework and how thedeficiencies can be overcome. We also enumerate how Islamicbanking can be made a viable alternative banking system inBangladesh. In this regard, we explain the main differencesbetween a conventional interest-based banking system and aninterest-free Islamic banking system. We utilize data collected fromthe Bank Scope and Individual Banking financial statements toshow the operational differences of these two banking systems inBangladesh. We finally conclude the article with specific policy rec-ommendations.

THE BANKING SYSTEM OF BANGLADESH

Current Status of Banking SystemThe Government of Bangladesh has attached much importance toexpanding banking activities. In the decade after liberation, there wasa tremendous growth of bank branches and expansion of bank busi-ness in both volume and dimension. In order to foster the economicgrowth and socioeconomic development of the country, theBangladesh government in 19721 nationalized the country’s bankingsystem, with the exception of branches of eight foreign banks. Morerecently, however, significant changes have taken place in the bank-ing system of the country. Government policy has become one ofencouraging the private sector to play its due role in the economicdevelopment of the country, and the government has allowed the set-ting up of commercial and investment banks in the private sector. Inresponse to the new policy, a number of private commercial andinvestment banks have been set up and have started functioning.Overall, the banking system of Bangladesh now consists ofBangladesh Bank (BB) as the central bank, and 51 commercial bankscomprising four nationalized commercial banks (NCB), five govern-ment-owned specialized banks, 29 domestic private banks, and 13foreign commercial banks. The system is dominated by the fournationalized commercial banks, which together controlled more than54% of deposits and operated 3,612 branches (58% of the total) as ofJune 30, 2001. Of the five government-owned specialized banks, two(Bangladesh Krishi Bank and Rajshahi Krishi Unnayan Bank) werecreated to meet the credit needs of the agricultural sector, while twoothers (Bangladesh Shilpa Bank and Bangladesh Shilpa Rin Sangtha)are for extending term loans to the industrial sector. The fifth bank(Karmasangstan Bank) provides loans to the youth with the sole pur-pose of reducing unemployment of skilled and semiskilled workers inthe country. Of the 51 local and foreign banks, six are Islamic and the

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The Governmentof Bangladesh

has attachedmuch impor-

tance to expand-ing banking

activities.

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rest are conventional banks.2 All private- and public-sector banksoperating in Bangladesh with different paid-up capital and reserveshaving a minimum aggregate value of Tk. 5 million and conductingtheir affairs to the satisfaction of Bangladesh Bank have been declaredas scheduled banks in terms of Section 37 (2) of the Bangladesh BankOrder 1972. Currently, in terms of Section 13 of the Bank Compa-nies Act 1991, the minimum aggregate value is Tk. 200 million.3

The six Islamic banks operating in the private sector are Islami BankBangladesh Limited, Al-Baraka Bank Bangladesh Limited, Al-ArafahIslami Bank Limited, Social Investment Bank Limited, Shamil Bankof Bahrain E.C., and Shahjalal Bank Limited. Shamil Bank of BahrainE.C. (previously known as Faysal Islamic Bank of Bahrain E.C.) is aforeign bank and is the largest Islamic bank in the world. It openeda branch in Bangladesh in 1998. In addition to these Islamic banks,two other private banks—Prime Bank Limited and Dhaka Bank Lim-ited—have opened two Islamic banking branches and an Islamicbanking counter, respectively, to deal with the Islamic banking busi-ness parallel to their conventional interest-based banking operationssince the commencement of the banks in 1995. Also, four Islamicinsurance companies (Islamic Insurance Bangladesh Limited, IslamicCommercial Insurance Limited, Takaful Insurance Company Lim-ited, and Far East Islamic Life Insurance Company Limited) are func-tioning as Islamic financial institutions in Bangladesh.4

Banking Regulations in BangladeshBanks and financial institutions in Bangladesh are governed by theBank Companies Act 1991, the Bangladesh Bank Order 1972, theSecurities and Exchange Commission Act 1993, and the Income TaxOrdinance 1984. Banking regulations provide a working frameworkfor banking companies that accept deposits from the public for lend-ing or investment. The task of regulating and monitoring both con-ventional and Islamic banking systems of Bangladesh is given toBangladesh Bank—the central bank of the country. As such,Bangladesh Bank has legal authority to supervise and regulate all thebanks—including Islamic banks—in Bangladesh. In addition to per-forming the traditional central banking roles of note issuance andbeing banker to the government and banks, it formulates and imple-ments monetary policy, manages foreign exchange reserves, andsupervises banks and nonbank financial institutions. Its prudentialregulations include: minimum capital requirements, limits on loanconcentration and insider borrowing and guidelines for asset classifi-cation and income recognition. Bangladesh Bank has the power toimpose penalties for noncompliance and also to intervene in the man-

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Banking regula-tions provide aworking frame-work for bankingcompanies thataccept depositsfrom the publicfor lending orinvestment.

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agement of a bank if serious problems arise (Sarker, 1998). It also hasthe delegated authority of issuing policy directives regarding the for-eign exchange regime. It has an issue and a banking control depart-ment to carry out its broad objectives, which include:

1. To regulate the issue of the currency and the keeping ofreserves;

2. To manage the monetary and credit system of Bangladesh,with a view to stabilizing domestic monetary value;

3. To preserve the par value of the Bangladesh Taka;4. To promote and maintain a high level of production, employ-

ment, and real income in Bangladesh and to foster growth anddevelopment of the country’s productive resources for thenational interest.5

It follows from the above that the Islamic banks in Bangladesh, beingpart of the financial system, are subject to the regulation and supervisionof Bangladesh Bank. In general terms, a policy of equal treatment for allconventional and Islamic banks is being followed by Bangladesh Bank.However, in view of the lack of Islamic financial markets and instru-ments in the country, Bangladesh Bank had granted some preferentialprovisions for the development of Islamic banking in Bangladesh.Among these provisions, the following are of great importance:

1. Since there are no profit-and-loss-bearing securities inBangladesh, Islamic banks have been allowed to maintain theirStatutory Liquidity Requirement (SLR) with BangladeshBank6 at the rate of 10% of their total deposit liabilities (CashReserve Requirement [CRR] at 5% and SupplementaryReserve Requirement [SRR] at 5% in approved securities),whereas the requirement is 20% for conventional banks inBangladesh. This discriminating provision had allowed theIslamic banks to divert some liquid funds for investment andthereby generate extra profit.

2. Under the indirect monetary policy regime, Islamic bankswere allowed independent scope to fix their profit-and-losssharing (PLS) ratios and markups commensurate with theirown policy and banking environment. This freedom in fixingPLS ratios and markup rates has provided scope for Islamicbanks to follow the Shariah principles independently.

3. Islamic banks could reimburse 10% of their proportionateadministrative cost on a part of their balances held withBangladesh Bank. This facility has given some scope forenhancement of their profit base (Hassan & Chowdhury, 2004).

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In general terms,a policy of equaltreatment for all

conventional andIslamic banks is

being followed byBangladesh

Bank.

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ISLAMIC BANKING REGULATIONS IN BANGLADESH

The Legal Framework of Islamic Banks in BangladeshUnlike Bangladesh, in most Muslim countries a special law is passedprior to the establishment of an Islamic bank that specifies the rulesand regulations for the institution willing to engage in banking busi-ness based on Islamic principles. In Malaysia, for example, the IslamicBanking Act 1983 was passed by Parliament prior to the establish-ment of the Bank Islam Malaysia Berhad in 1983, and this law appliesto any Islamic banking institutions wishing to operate in Malaysia(Haron, 1997, p. 174). However, despite having their own laws,Islamic banks in most Muslim countries have to conform to otherlaws and regulations. Similarly, in the case of disputes or legal actionsbetween banks and their customers, matters are referred to civilcourts. For instance, the commercial transactions of Islamic banks inMalaysia come within the jurisdiction of the civil court. Therefore,any legal proceedings between Islamic banks and their customers areto be handled by the normal civil court (Haron, 1997, p. 181).

In Bangladesh, there is no separate Islamic banking act or any specificlaws or independent regulations that control, guide, and supervise thefunctions of Islamic banks (Ahmad, 2004). Bangladesh Bank exercisesauthority over Islamic banks under laws and regulations engineered tocontrol and supervise traditional banks whose goals and functions aredifferent from Islamic banks. Moreover, Bangladesh Bank did not setup any separate department to control and supervise the operation ofIslamic banks. Inspection and supervision of Islamic banks’ operationare being scrutinized by Bangladesh Bank as per general rules andguidelines set for conventional banks. However, all existing Islamicbanks of the country are incorporated as companies limited by shares;thus, they are subjected to the Companies Law of the country. Theywere incorporated as interest-free Shariah-based commercial banksand public limited companies with limited liabilities as well, under theCompanies Act 1994 (Act No. 18 of 1994, Section 2). Besides, allkinds of commercial banking services of Islamic banks in Bangladeshare provided by them with their branches to their customers followingthe provisions of the Bank Companies Act 1991 (Act No. 14 of1991), Bangladesh Bank’s directives, and the principles of IslamicShariah. Among the provisions in these Companies Laws are theeffects of incorporation, matters related to finance, management andcontrol of the company, and liquidation.

The Bank Companies Act 1991 empowers Bangladesh Bank to issuelicenses to carry out banking business in Bangladesh. Pursuant to

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In Bangladesh,there is no sepa-rate Islamicbanking act orany specific lawsor independentregulations thatcontrol, guide,and supervisethe functions ofIslamic banks.

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Section 31 of the Act, before granting a license, Bangladesh Bankneeds to be satisfied that the following conditions are fulfilled:

• that the company is or will be in a position to pay its presentor future depositors in full as their claims accrue;

• that the affairs of the company are not being or are not likelyto be conducted in a manner detrimental to the interest of itspresent and future depositors; and

• that, in the case of a company incorporated outsideBangladesh, the government or law of the country in which itis incorporated provides the same facilities to banking compa-nies registered in Bangladesh as the government or law ofBangladesh grants to banking companies incorporated outsideBangladesh and that the company complies with all applicableprovisions of the Bank Companies Act 1991.7

Licenses may be cancelled if the bank fails to comply with the aboveprovisions or ceases to carry on banking business in Bangladesh.

Beside the Acts mentioned above, the Securities and Exchange Com-mission in Bangladesh exercises powers under the Securities andExchange Commission Act 1993. It regulates financial institutionsengaged in capital market activities. Bangladesh Bank exercises pow-ers under the Financial Institutions Act 1993 and regulates institu-tions engaged in financing activities.

There are also various requirements to be adhered to by the Islamicbanks like other companies in Bangladesh once they are establishedunder the Companies Acts. One of the most important requirementsin this regard is that the Islamic banks have to have their own consti-tutions called Memorandums and Articles of Association. Articles ofAssociation for an ordinary company basically contain provisions thatspecify the nature, objectives, and capital structure of the company;regulations on the allotment and issue of shares; call on shares; howthe capital may be altered, the calling of general meetings; and theprocedure at those meetings. They also prescribe rules for the pow-ers, duties, manner of appointment, share qualification, and proceed-ings of directors; the secretary and company seal and how dividendsare to be declared and reserves provided. In addition to these com-mon provisions, Islamic banks in Bangladesh usually include twomore clauses or articles in their Articles of Association. First, there isa clause that prescribes that their operations are free from any ele-ment of interest. Second, a clause is included pertaining to theappointment of a Shariah Council/Board.

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One of the mostimportant

requirements inthis regard is thatthe Islamic banks

have to havetheir own consti-

tutions calledMemorandumsand Articles of

Association.

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The Development of Legal Framework of Islamic Banks inBangladeshThe laws and regulations that regulate the banking system inBangladesh were designed to govern the interest-based financial insti-tutions and are thus not applicable to Islamic banks. However,although Islamic banks in Bangladesh have been granted licenses byBangladesh Bank subsequently, at their recommendation, severalclauses were incorporated in the Bank Company Act regarding themechanism of Islamic banking. Also, some necessary amendmentshave been made in the country’s Income Tax Ordinance—theIncome Tax Ordinance 1984 (XXXVI of 1984)—allowing theamount of profit shared by the investment clients with the Islamicbanks as expenditure and the amount of profit paid on Mudarabahdeposits by the Islamic banks as expenditure. Section 29 of the afore-said Ordinance (as amended up to June 2002) reads, under the sub-title “Deductions from income from business or profession,”

In computing the income under the head “Income from business orprofession,” the following allowances and deductions shall beallowed, namely:

. . . the amount of any interest paid or any profit shared with abank run on Islamic principles in respect of capital borrowed forthe purposes of the business or profession;

Provided that if any part of such capital relates to replenishing thecash or to any other asset transferred to a newly set-up industrialundertaking whose income is exempted from payment of tax, theamount shall be proportionate part of the interest so paid or theprofit so shared having regard to the proportion of such capital soused;

any sum paid or credited to any person maintaining a profit andloss sharing account or deposit with a bank run on Islamic princi-ples by way of distribution of profits by the said bank in respectof the said account of deposit.8

Alongside the development of a legal framework of Islamic banking,Bangladesh Bank provides other forms of cooperation with Islamicbanks. The setting up of the internal and Islamic economics divisionunder the Department of Research by Bangladesh Bank is a majordevelopment in this regard (Ahmad, 2006). Another development, asmentioned earlier in this study, is the special provision that has beenmade by Bangladesh Bank for the Statutory Liquidity Reserve (SLR)requirement of Islamic banks. In case of need, Bangladesh Bank, asthe lender of last resort, may place funds in Mudarabah accounts with

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The setting up ofthe internal andIslamic eco-nomics divisionunder theDepartment ofResearch byBangladeshBank is a majordevelopment…

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Islamic banks and share profit in line with the principles of the distri-bution of profits to Mudarabah depositors. Other major develop-ments include:

1. Incorporating some legal provisions in the amended BankCompanies Act 1991;

2. Using the CAMEL-rating framework9 by Bangladesh Bank foranalysis of the operational risks of Islamic banks; and

3. Conducting research in order to devise a separate Islamicbanking inspection methodology for Islamic banks.

In terms of providing legal support for solving various problems aris-ing from interest-free banking transactions in the present traditionalregulatory system of the country, Bangladesh Bank saw value in hav-ing an independent Islamic Banking Act like Malaysia, Turkey, Jor-dan, and Kuwait. Such law would incorporate provisions relating tothe licensing of Islamic banks; the financial requirements and dutiesof Islamic banks; ownership, control, and management of Islamicbanks; restriction on business, and powers of supervision and controlover Islamic banks. A letter issued by Bangladesh Bank to all theIslamic banks and banks having Islamic banking branches and coun-ters on March 15, 1997, sought suggestions on six major areasrelated to the development of Islamic banking in Bangladesh, includ-ing (1) formation of an Islamic money market, (2) establishing a cen-tral Shariah Board, (3) preparing an Islamic Banking Act, and (4)constitution of consortiums/syndication by the Islamic banks forlarge financing.10 After receiving feedback on these issues,Bangladesh Bank subsequently prepared a draft Islamic Banking Actto be included in the Bank Companies Act 1991. Following approvalfrom the Ministry of Law, Justice, and Parliamentary Affairs, intro-duction of the proposed Islamic Banking Act bill in the Parliament isat an advanced stage.

CONCEPTUAL DIFFERENCES BETWEEN ISLAMIC ANDCONVENTIONAL BANKS

The philosophical foundation of an Islamic financial system, withbanking the most developed part, goes beyond the interaction of fac-tors of production and economic behavior (Nienhaus, 1994).Whereas the conventional financial system focuses primarily on theeconomic and financial aspects of transactions, the Islamic systemplaces equal emphasis on the ethical, moral, social, and religiousdimensions, to enhance equality and fairness for the good of society

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The philosophi-cal foundation ofan Islamic finan-cial system, with

banking themost developed

part, goesbeyond the

interaction offactors of pro-

duction and eco-nomic behavior.

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as a whole (Akkas, 1996). The similarities between the two systemsare that banks in an Islamic system, although controlled by the rulesof Shariah, essentially perform the same functions as those in a con-ventional system; that is, they act as administrators of the economy’spayments system and as financial intermediaries (Ebrahim & Joo,

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Table 1. Cost of Fixing the Year 2000 Problem

Conventional banking Islamic banking1. The functions and operating modes

of conventional banks are based onman-made principles.

2. The investor is assured of a predeter-mined rate of interest.

3. It aims to maximize profit withoutany restriction.

4. It does not deal with zakah.

5. Lending money and getting it backwith interest is the fundamentalfunction of the conventional banks.

6. Its scope of activities is narrowerwhen compared with an Islamicbank.

7. It can charge additional money(compound rate of interest) in caseof defaulters.

8. In it, the bank’s own interest veryoften becomes prominent. Itmakes no effort to ensure growthwith equity.

9. For interest-based commercial banks,borrowing from the money marketis relatively easier.

10. Since income from the advances isfixed, it gives little importance todeveloping expertise in projectappraisal and evaluations.

11. Conventional banks place greateremphasis on creditworthiness ofthe clients.

12. The status of a conventional bankin relation to its clients is that ofcreditor and debtors.

13. A conventional bank has to guaran-tee all its deposits.

1. The functions and operating modesof Islamic banks are based on theprinciples of Islamic Shariah.

2. In contrast, it promotes risk sharingbetween provider of capital(investor) and the user of funds(entrepreneur).

3. It also aims to maximize profit, butsubject to Shariah restrictions.

4. In the modern Islamic banking sys-tem, it has become one of the ser-vice-oriented functions of theIslamic banks to collect and dis-tribute zakah.

5. Participation in partnership businessis the fundamental function of theIslamic banks.

6. Its scope of activities is wider whencompared with a conventionalbank. It is, in effect, a multipur-pose institution.

7. The Islamic banks have no provisionto charge any extra money fromthe defaulters.

8. It gives due importance to the publicinterest. Its ultimate aim is toensure growth with equity.

9. For Islamic banks, it is comparativelydifficult to borrow money from themoney market.

10. Since it shares profit and loss,Islamic banks pay greater attentionto developing project appraisal andevaluations.

11. Islamic banks, on the other hand,place greater emphasis on the via-bility of the projects.

12. The status of the Islamic bank inrelation to its clients is that of part-ners, investors, and traders.

13. Strictly speaking, an Islamic bankcannot guarantee all its deposits.

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2001). They are needed in both systems for the same reason—for theexploitation of imperfections in financial markets. These imperfec-tions include imperfect divisibility of financial claims, imperfect infor-mation, transaction costs of search and acquisition, diversification bythe surplus and deficit units, and existence of expertise andeconomies of scale in monitoring transactions (Iqbal & Mirakhor,1987, p. 3). Financial intermediaries in an Islamic system that oper-ate in accordance with Shariah can reasonably be expected to exhibiteconomies of scale with respect to these costs, as do their counter-parts in a conventional system. Just as in the latter system, the Islamicdepository financial intermediaries transform the liabilities of businessinto a variety of obligations to suit the tastes and circumstances of thesurplus units (Hassan & Tarek, 2001; Siddiqi, 1983).

Due to the nature of their operation, on the other hand, there are dif-ferences between Islamic and conventional banking. Conventionalbanking has been defined as “accepting, for the purpose of lendingor investing, deposits of money from the public, repayable ondemand or otherwise, and withdrawable by cheque, draft, order orotherwise” (Meenai, 1998, p. 3). Islamic banking has been definedby the International Association of Islamic Banks (IAIB) as “theIslamic Bank basically implements a new banking concept in that itadheres strictly to the rules of Islamic Shariah in the fields of financeand other dealings. Moreover the Bank functioning in this way mustreflect Islamic principles in real life. The Bank should work towardsthe establishment of an Islamic society. Hence, one of its primarygoals is the deepening of religious spirit among the people.”11 Thus,it is evident that Islamic banking is different from conventional bank-ing in terms of its mission and objectives, and the obligations towardsociety greater than conventional banks, for the following reasons:

1. To achieve certain philosophical missions of Islamic banking(that is, since God is the Creator and Ultimate Owner of allresources, institutions or persons have a vicegerency role toplay in society. Therefore, Islamic banks are not free to do asthey wish; rather, they have to integrate moral values with eco-nomic action.);

2. To provide credit to those who have the talent and the exper-tise but cannot provide collateral to the conventional financialinstitutions, thereby strengthening the grass-roots foundationsof society; and

3. To create harmony in society based on the Islamic concept ofsharing and caring in order to achieve economic, financial, andpolitical stability (Hassan & Adnan, 1998, 1999).

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Financial inter-mediaries in anIslamic systemthat operate in

accordance withShariah can rea-

sonably beexpected to

exhibiteconomies of

scale withrespect to these

costs, as do theircounterparts in a

conventionalsystem.

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Conventional banking is essentially based on the debtor-creditor rela-tionship between the depositors and the bank on the one hand andbetween the borrowers and the bank on the other, with interest as theprice of credit, reflecting the opportunity cost of money. In Islamicbanking, the creditor should not take advantage of the borrower (Al-Omar & Abdel-Haq, 1996). When money is lent out on the basis ofinterest, often it leads to some kind of injustice. The first Islamic prin-ciple underlying such kinds of transactions is:

Deal not unjustly, and you shall not be dealt with unjustly [2:279].

Accordingly, commercial banking in an Islamic framework is notbased on the debtor-creditor relationship (Hassan & Tariq, 1992).

The second principle regarding financial transactions in Islam is thatthere should not be any reward without taking a risk. This principleis applicable to both labor and capital (Ahmad, 1993). As no paymentis allowed for labor, unless it is applied to work, there is no reward forcapital unless it is exposed to business risk (A. Ahmad, 1995, p. 17;Hassan, 1999).

Financial intermediation in an Islamic framework has been developedon the basis of the above two principles. Consequently, financial rela-tionships in Islam have been participatory in nature and the institu-tion of interest replaced by a principle of participation in profit andloss (Chapra, 1985). That means a fixed (or predetermined) rate ofinterest is replaced by a variable rate of return based on real economicactivities (Mangla & Uppal, 1990, pp. 179, 185, 215).

The distinct characteristics that provide Islamic banking with its mainpoints of departure from the traditional interest-based commercialbanking system are: (a) the Islamic banking system is essentially aprofit-and-loss sharing system and not an interest banking system and(b) investment (loans and advances in the conventional sense) underthis system of banking must serve simultaneously both the benefit tothe investor and the benefit of the local community as well. The dis-tinguishing features of the conventional banking and Islamic bankingare summarized in Table 1.

In spite of the differences between the Islamic and conventional banks,both have something in common. Since Islamic banks do not rentmoney, and therefore do not charge interest, they have developed someinvestment techniques such as bai’ murabahah, musharakah, andmudarabah in order to invest money and make profit (Haron, 2004). In

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…financial rela-tionships inIslam have beenparticipatory innature and theinstitution ofinterest replacedby a principle ofparticipation inprofit and loss.

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any of these techniques, profitability and installment of repayment areidentified beforehand. In addition, some Islamic banks practice certainforms of leasing. Many of the services handled by conventional banks andnot related to interest, such as letters of credits, collections, foreignexchange, financial advising, and the like, are performed by Islamicbanks. Some Muslim banks handle a large percentage of the Islamicbank’s money in the commodities markets. If it is considered that banksand financial institutions measure their success in terms of return onassets (ROA), the commodity transaction can be developed to achievethe goals of the parties concerned—the Islamic bank, the conventionalbank, and the client of the conventional bank (Qasim, 1986, pp. 19–20).

OPERATIONAL DIFFERENCES BETWEEN ISLAMIC ANDCONVENTIONAL BANKS

We have collected balance-sheet and income-statement data on thebanking system in Bangladesh. The primary source of data is BankScope, and the secondary source of data is the Islami BankBangladesh Limited. Table 2 shows the average asset quality ratios forthe Bangladeshi Banking System, classified by type of institutions,and the same indices for Islami Bank Bangladesh Limited (IBBL).The first ratio, Loan Loss Reserve/Gross Loans, indicates how muchof the total portfolio has been provided for but not charged off.

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Table 2. Asset Quality Ratios for Bangladesh Banking System(Average 1994–2001 Period)

Islami Bank SpecializedBangladesh Governmental

Limited Credit(IBBL) Public Islamic Commercial Institutions

Loan Loss Reserve/Gross Loans 7.29 3.07b 4.47 3.64 13.38w

Loan Loss Provision/Net Interest Revenue 62.33w 36.56 51.42 33.54 0.12b

Loan Loss Reserve /Impaired Loans n.a. 18.00w 63.03 30.23 179.11b

Impaired Loans/Gross Loans n.a. 14.75 10.35b 11.18 32.22NCO/Average Gross Loans 1.02 0.09 0.89w –0.27b –0.08NCO/Net Income Before Loan Loss Provision 47.00 35.73w 35.49 1.63 –27.48b

b: best outcomew: worst outcomeData Source: Bank Scope (2003).

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Given a similar charge-off policy, the higher the ratio is, the poorerthe quality of the loan portfolio. In this case, specialized governmen-tal credit institutions have the worst ratio (Huq, 1996). The Gov-ernment of Bangladesh uses these outlets to direct credit to sociallydesirable sectors, and hence they have less than normal performances.There is very little difference among public, commercial, and Islamicbanks in loan loss reserve ratio. The IBBL shows worse performancecompared to other commercial banks, but better than the specializedgovernmental credit institutions sector.

Loan Loss Provision/Net Interest Revenue is the relationshipbetween provisions in the profit-and-loss account and the interestincome over the same period. Ideally, this ratio should be as low aspossible. In a well-run bank, if the lending book is higher in risk, thiswould be reflected by higher interest margins. If the ratio deterio-rates, this means that risk is not being properly remunerated by mar-gins. There is not much difference between public and private com-mercial banks in this ratio. Specialized governmental creditinstitutions have the best ratio, but it does not reflect their good per-formance because they are making enough loan loss provision in theirfinancial statements. The IBBL has the worst ratio, even worse thanthose of Islamic banks as a group.

Loan Loss Reserve/Impaired Loans (nonperforming loans) relatesloan loss reserves to nonperforming or impaired loans. The higherthis ratio is, the better provided the bank is, and the better the loanquality. The Islamic banks have the best performance according tothis ratio, followed by private commercial banks and public banks.

Impaired Loans (nonperforming loans)/Gross Loans is a measure ofthe amount of total loans, which are doubtful. The lower this figureis, the better the asset quality. Islamic banks show the best ratio, fol-lowed by private commercial banks and public commercial banks.

Net Charge-Off (NCO), or the amount written off from loan lossreserves less recoveries, is measured as a percentage of the gross loans. Itindicates what percentage of today’s loans have been finally been writtenoff the books. The lower this figure is, the better the performance. In thismeasure, the Islamic banks performance is less than the other banks.

Finally, NCO/Net Income Before Loan Loss Provision measurescharge-offs against income generated in the year. The lower this fig-ure is, the better the performance. The private commercial bankshave the best performance in this measure.

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There is very lit-tle differenceamong public,commercial, andIslamic banks inloan loss reserveratio.

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In summary, we cannot conclusively argue which type of bank has thebest asset quality performance. There is basically no differencebetween Islamic banks and private commercial banks. The fact thatthe specialized governmental credit institutions have better assetquality than others is not surprising, because these institutions aresubsidized by the government.

Table 3 shows various measures of capital ratios. All the capital ratiosare ways of looking at the equity funding of the balance sheet and oflooking at capital adequacy. For example, the Equity/Total Assetsratio measures the amount of protection afforded to the bank by theequity they invested in it. The higher these ratios are, the more theprotection. Equity/Net Loans measures the equity cushion availableto absorb losses on the loan book. Equity/Customer and Short-Term Funding measures the amount of permanent funding relativeto short-term, potentially volatile funding. The higher the ratio is,the better the performance. Equity/Liabilities is simply another wayof looking at the equity funding of the balance sheet and is anotherway of looking at capital adequacy. In capital ratio measures, Islamicbanks are in general the best capitalized, followed by commercial andpublic banks. Commercial banks have better capital ratios than those

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Table 3. Capital Ratios for Bangladesh Banking System(Average 1994–2001 Period)

Islami Bank SpecializedBangladesh Governmental

Limited Credit(IBBL) Public Islamic Commercial Institutions

Equity/Total Assets 5.32b 2.71 4.38 3.31 –1.96w

Equity/Net Loans 13.59b 4.76 10.60 5.76 –2.82w

Equity/Customer and Short-Term Funding 6.47b 3.03 5.19 3.87 –2.49w

Equity/Liabilities 5.63b 2.79 4.60 3.46 –1.26w

Capital Funds/Total Assets n.a. 2.71 4.38b 3.31 –1.69w

Capital Funds/Net Loans n.a. 4.76 10.60b 5.76 –2.40w

Capital Funds/ Customer and Short-Term Funding n.a. 3.03 5.19b 3.87 –2.15w

Capital Funds/Liabilities 5.63 2.79 4.60b 3.46 –0.97w

b: best outcomew: worst outcomeData Source: Bank Scope (2003).

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of public commercial banks. The specialized banks have the worstratio. The IBBL has the best capital adequacy performance among allcommercial banks and specialized banks.

Table 4 presents the operational ratios for the Bangladeshi bankingsystem. The first three ratios, Net Interest Margin, Net InterestIncome/Average Assets, and Other Operating Income/AverageAssets, are measures of productivity of the assets (Ahmed, 1999; Has-san & Abdel-Hamid, 2003). The net interest margin is expressed asNet Interest Income/Earning Assets. The higher the ratio, thecheaper the funding or the higher the margin the bank is command-ing. Higher margins and profitability are desirable so long as the assetquality is being maintained. Other Operating Income/Average Assets

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Table 4. Operations Ratios for Bangladesh Banking System(Average 1994–2001 Period)

Islami Bank SpecializedBangladesh Governmental

Limited Credit(IBBL) Public Islamic Commercial Institutions

Net Profit Margin 1.41 1.00 1.03 1.77b –0.24w

Net Interest Income/Average Assets 1.00 0.85 0.76 1.52b –0.15w

Other Operating Income/Average Assets 2.29 1.21 2.04 2.45b 0.42w

Noninterest Expenses/Average Assets 2.30 1.89 2.19b 2.78 3.19w

Pretax Operating Income/Average Assets 1.00 0.27 1.03 1.47b –3.81w

Nonoperating Items and Taxes/Average Assets –0.15 0.06b 0.57 0.62w 0.10Return on Average Assets (ROAA) 0.85 0.21 0.45 0.85b –3.33w

Return on Average Equity (ROAE) 17.92 7.16 7.04w 52.97b

Dividend Pay-Out 46.88 19.45Income Net of Distribution/Average Equity 11.95 8.74 –0.24w 49.45b

Nonoperating Items/Net Income 41.39 27.18 123.19 43.03Cost to Income Ratio 58.98 89.86w 71.31 64.49b

Recurring Earning Power 1.87 0.25 2.24 2.57b –2.67w

b: best outcomew: worst outcomeSource: Bank Scope (2003).

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shows fee income earned by the banks. As long as this is not volatiletrading income, it is a lower risk form of income. Commercial banksshow the best performance in this category. Islamic banks still have tocatch up with their conventional counterparts in improving their oper-ational performance.

The fourth ratio, Noninterest Expenses or Overheads Plus Provi-sions, gives a measure of the cost side of the banks performance rel-ative to the assets invested. The lower the ratio is, the better the per-formance. Islamic banks have the best performance in this category.

Pretax Operating Income/Average Assets measures the operating per-formance of the bank before tax and unusual items. This is a goodmeasure of profitability unaffected by one-off nontrading activities.The higher this value is, the better the performance. Again, commer-cial banks show the best outcome, followed by Islamic banks. Non-operating Items & Taxes/Average Assets measures the costs and taxas a percentage of assets. The lower the ratio is, the better the perfor-mance. Public banks have the lowest ratio, because they are owned bythe government and do not pay taxes directly. The commercial bankshave the worst ratio, because they have to pay taxes to the Exchequer.

Return on Average Equity (ROAE) and Return on Average Assets(ROAA) measure the performance relative to equity and assets,respectively. There is no difference between private commercial banksand IBBL in ROAA, but private commercial banks have better ROAEprecisely because their leverage ratios are higher than IBBL. Islamicbanks and public commercial banks have almost similar performanceratios.

Income Net of Distribution/Average Equity is the return on equityafter deducting the dividend from the return and it shows by whatpercentage the equity has increased from internally generated funds.The higher the ratio is, the better the performance. Commercialbanks present the best performance, followed by IBBL.

Nonoperating Items/Net Income shows the percentage of unusualincome generated by banking activities. Islamic banking fundingoperations are different from those of private commercial banks, andwe find Islamic banks have more nonoperating income than com-mercial banks do.

Cost to Income Ratio measures the overheads or costs of running thebank. It is a measure of efficiency, and the higher the ratio is, the worse

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Islamic bankingfunding opera-

tions are differ-ent from those ofprivate commer-

cial banks, andwe find Islamic

banks havemore nonoperat-ing income than

commercialbanks do.

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the performance. The IBBL has the best performance ratio, followedby the private commercial banks and public banks (Hassan & Muza-hidul, 2003). Recurring Earning Power measures tax profits, addingback provisions for bad debts as a percentage of total assets. In otherwords, this is a measure of asset performance without deducting pro-visions. The commercial banks have the best performance in this mea-sure, followed by Islamic banks and public commercial banks.

In summary, commercial private banks have the highest operatingperformance, followed by Islamic banks and public banks. Specializedgovernmental credit institutions and public banks do not have com-parably good performance results. Even thought they are nonprofitorganizations, they should improve their performance to ensure theirexistence in the long run. Finally, IBBL shows better ratios than theIslamic banks’ average.

Table 5 shows the liquidity ratios for the Bangladeshi banking system.With the exception of Net Loans/Total Assets, Islamic banks presentthe higher values, confirming the fact that the Islamic banks haveexcess liquidity. Net Loans/Total Assets indicates what percentage ofthe assets of the bank are tied up in loans. The higher the ratio is, theless liquid the bank is. Net Loans/Customer and Short-Term Fund-ing is another measure of liquidity, with a high number showing a

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Table 5. Liquidity Ratios for Bangladesh Banking System(Average 1994–2001 Period)

Islami Bank SpecializedBangladesh Governmental

Limited Credit(IBBL) Public Islamic Commercial Institutions

Interbank Ratio 54.67 230.48Net Loans/Total Assets 66.57 57.18b 52.61b 57.35 65.92w

Net Loans/Customerand Short-Term

Funding 55.59 64.35 61.99b 65.46 89.50w

Net Loans/Total Deposits and Borrowing 31.47 63.94 61.99b 65.45 89.42w

Liquid Assets/Customer and Short-Term Funding 32.77 14.60 32.80b 27.55 4.96w

Liquid Assets/Total Deposits and Borrowing 54.67 14.51 32.80b 27.54 4.96w

b: best outcomew: worst outcomeSource: Bank Scope (2003).

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worse liquidity measure. The higher Net Loans/Total Deposits andBorrowing is, the lower the liquidity of the bank is. The higher Liq-uid Assets/Customer and Short-Term Funding is, the higher the liq-uidity. Specialized governmental credit institutions are highly illiquid.The IBBL has ratios similar to the Islamic banking sector average.

THE PROSPECTS OF ISLAMIC BANKS IN BANGLADESH

The future of Islamic banks hinges, by and large, on their ability to finda viable alternative to interest for financing all types of loans. Therefore,Islamic banks in Bangladesh should recognize the fact that their successin abolishing interest has been only partial and they have a long way togo in their search for a satisfactory alternative to interest. Simultane-ously, Islamic banks need to improve their managerial capabilities bytraining their personnel in project appraisal, monitoring, evaluation,and performance auditing (Hassan & Mahmood, 2001). Moreover,the future of Islamic banks in Bangladesh also depends on developingand putting into practice such accounting standards that provide timelyand reliable information of the type that the Islamic banks wouldrequire for profit sharing, rent sharing, or cost-plus financing. Thesestandards are yet to be developed. The Islamic banks would have towork hard to pursue their clients to accept these standards so that a reli-able information base is established.

In this light, Islamic banking in Bangladesh would be regarded asIslamically successful in the future if it succeeds simultaneously bothin eradicating interest from its transactions and in promoting com-merce and trade. Islamic banks may and should concentrate exclu-sively on acceptable and profitable economic activity, such as trading,for instance, in commodities, property investment, property develop-ment, and asset leasing. They should solicit deposits for direct invest-ment in those activities and trade, therefore, as quasi-investmentbanks. At the same time, they cannot, like any other financial institu-tion, ignore the realities and costs of inflation, which permeate theinternational economy. They can best solve this problem by beingprofitable enough to meet the need to maintain the value of theirdepositors’ funds.

It might be argued that Islamic banks can become complacent andtake it for granted that they have a captive market in the Muslimmasses who will come to them on religious grounds. Such com-placency seems more pronounced in countries with only oneIslamic bank. Many Muslims find it more convenient to deal with

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Islamic banks inBangladesh

should recognizethe fact that

their success inabolishing inter-

est has beenonly partial and

they have a longway to go in

their search for asatisfactory

alternative tointerest.

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conventional banks and have no qualms about shifting theirdeposits between Islamic banks and conventional ones dependingon which bank offers a better return. This might suggest a case formore Islamic banks in those countries, so as to force the banks tobe more innovative and competitive. Another solution would be toallow the conventional banks to undertake equity financingand/or to operate Islamic “counters” or “windows,” subject tostrict compliance with Shariah rules. It is also suggested that somespecialized Islamic financial institutions such as mudarabah banks,murabahah banks, and musharakah banks establish in the countryto compete with one another and provide the best possible servicesfor the clients.

Both the survival and vitality of Islamic banks depend ultimately onthe quality of the services offered to clients (Khan, 1986). Failure toprovide the full range of high-quality services will inevitably meanthat clients will switch from the Islamic counters to conventionalbanks (Khan, 270). The Islamic banks should, as a first step, learnfrom the techniques and experience of conventional banking in orderto improve their marketing techniques and define and deliver servicesto clients. Second, the Islamic banks must institute a formal, struc-tured staff-training program. The staff needs training in the relevantareas of Islamic law, as well as in conventional financial techniques(Ahmad, 2001).

The future of Islamic banking in Bangladesh depends upon it prov-ing its usefulness to the nation from the point of view of sociallyresponsible investments. There will always be a question mark overthe real difference between it and conventional banking. It is impor-tant for people to see that Islamic banking gives a tangible form to itsreligious ideology. The problems and challenges it faces are to provethat it is possible to be both economically productive and compas-sionate, to seek both economic self-interest and the interest of oth-ers, and to show that there is no contradiction between ethics andprofessionalism, competence in one’s field, and a permanent com-mitment to good work in that field.

From this perspective, it might be better if Islamic banks were notfloated within the conventional banking framework. Instead, the con-ventional banking system’s operational mechanism ought perhaps tobe examined and converted into a PLS system, in view of the likelybeneficial impact of the latter on the economy. However, so long asIslamic banks are to operate within the conventional banking frame-work, the following recommendations seem pertinent.

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The future ofIslamic bankingin Bangladeshdepends upon itproving its use-fulness to thenation from thepoint of view ofsocially respon-sible invest-ments.

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Future Policy and StrategyIslamic banks must simultaneously promote the image of their Islam-icity and their solvency as banks. Pilot schemes in some selected areasshould be started to test innovative ideas with PLS modes of financ-ing as a major component. Islamic banks should demonstrate thattheir banking practices are guided by profitability criteria that rest onan efficient allocation of resources and provide true market signalsthrough PLS modes. At the same time, they should monitor and dis-seminate through various means the impact of their operations on thedistribution of income primarily between the bank and the depositorsand entrepreneurs, and then on different income groups of the coun-try. A fully equipped research academy within each Islamic bankwould assist this function.

Balance Between the Ideals and Practice There seems to be a gap between the ideals and actual practice ofIslamic banks in Bangladesh. In their reports, booklets, bulletins, andposters, these banks express their commitment to a just society freefrom exploitation. While the failure to achieve this goal is attributedmainly to the pervasive influence of conventional banking systemitself, a lack of vigilance of the promoters of Islamic banking in real-izing the objective is no less to blame. There should be a thoroughreview of policies that have been pursued by these banks over abouttwo decades, and points of departure have to be identified toredesign their course of action.

Promotion of Distributional Efficiency The task is more challenging for Islamic banks, as they have to pro-mote their distributional efficiency from all dimensions together withprofitability. Islamic banks, step by step, have to be converted intoPLS banks by increasing their percentage share of investment financ-ing. The Islamic banks, to do that, can be selective in choosing clientsfor financing under PLS modes. They should establish a direct func-tional relationship between the income of the depositors and betweenthe income of the bank and that of the entrepreneurs.

Promotion of Allocative EfficiencyIslamic banks can improve their allocative efficiency by satisfyingsocial welfare conditions in the following manner:

a) They should allocate a reasonable portion of their investiblefunds to social priority sectors such as agriculture (includingpoultry, fishery, etc.), small and cottage industries, and export-oriented industries.

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Islamic banks,step by step,

have to be con-verted into PLS

banks byincreasing their

percentageshare of invest-ment financing.

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b) Once the percentage shares of investible funds are allocatedamong the sectors of investment financing, the profitability ofprojects should be the criterion for allocating investmentfunds. The criterion would be satisfied if more and more pro-jects were financed under PLS modes.

Modern Banking PracticesIslamic banks, with a view to facing the growing competition eitherfrom fellow Islamic banks or the conventional banks that havelaunched Islamic banking practices, will have to adapt their function-ing in line with modern business practices through improvement ofthe range of transactions in the banking sector. Thus, it is necessaryfor them to provide comprehensive banking and investment servicesto clients and simultaneously to take advantage of modern commu-nication technology.

Responsibility of Central Bank Bangladesh Bank—the central bank of the country—should havemore responsibilities for the promotion of Islamic banking consider-ing its central roles. It can develop some Islamic monetary and sav-ing instruments and create a separate window for transactions withthe conventional banks. It can develop and update its Internal andIslamic Economics Division for analyzing, supervising, monitoring,and guiding purposes, thereby facilitating Islamic banks’ develop-ment in Bangladesh. Government support is also needed to introduceand thereby pass the Islamic Banking Act proposed by BangladeshBank.

In general, the success of Islamic banking depends heavily on its abil-ity to find a viable alternative to interest financing. The system mustrecognize and acknowledge that its success in abolishing interest hasbeen only partial, and that it still has a long way to go in its search fora satisfactory alternative. Improved managerial capabilities and train-ing of personnel in project appraisal, monitoring, evaluation, and per-formance auditing are important prerequisites. So also is putting intopractice accounting standards that provide timely and reliable infor-mation for profit sharing, rent sharing, or cost-plus financing trans-actions. Until these are done, it is an uphill task for Islamic banks topersuade clients who are not already persuaded to believe that they,the banks, have a sufficient and reliable information base from whichto conduct and expand their business.

It is important to remember that the Islamic banking movement inBangladesh has been in operation for only 22 years, so it is unfair to

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BangladeshBank—the cen-tral bank of thecountry—shouldhave moreresponsibilitiesfor the promo-tion of Islamicbanking consid-ering its centralroles.

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compare its results with those of the conventional banks, which havebeen established for many decades. Islamic banking is still an ongo-ing phenomenon. The challenge for Islamic banking is whether andhow to go on surviving, then to succeed and so become an estab-lished, permanent phenomenon.

CONCLUSIONS AND POLICY SUGGESTIONS

Islamic banks in Bangladesh came into existence with certainobjectives, in line with the philosophy of Islamic banking, thatimply a direct and specific responsibility on their part to play aneffective role in the socioeconomic development of the country. Itis apparent that Islamic banks have concentrated on short-termcommercial activities to maintain their place in the market. How-ever, achieving and maintaining high profit is also essential for thesuccess of the system.

Although the existing Shariah principles of banking and finance areconsidered sufficient to facilitate all modern banking products andservices, they should also include laws, practices, procedures, andinstruments that help in the maintenance and special consideration ofdistributive justice and equity. Areas like the banker-customer rela-tionship, legal underpinnings for the banks’ products and services,legal considerations varying the types of customers, duties andresponsibilities as a paying and collecting banker, legal actions againstthe customer, aspects of financing, and the like should be reviewedand tailored under Islamic Shariah.

Since the two monetary policy instruments used by Bangladesh Bank(namely, open market operations and discount rates) are not applica-ble to the Islamic banking system (unlike its conventional counter-part), alternative financial instruments permissible in Shariah are rec-ommended to be used by the Islamic banks. It is suggested thatBangladesh Bank should participate directly as a cofinancier on aprofit-sharing basis on projects financed by an Islamic bank.

The spread of Islamic banking in the country would improve theinterregional flows of funds, reduce the disparities in the cost of bor-rowing, and mobilize investment resources in the rural areas toimprove the living standards of the small and marginal farmers. Issuesof poverty and unemployment are major ones. Being one of thepoorest countries in the world and with limited job opportunities, alarge number of university graduates in Bangladesh are unemployed.

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It is suggestedthat Bangladesh

Bank should par-ticipate directlyas a cofinancieron a profit-shar-ing basis on pro-jects financed byan Islamic bank.

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Islamic banks could play an active role through their welfare-orientedactivities to create job opportunities for the graduates.

Bbai’ murabahah, or markup-based financing, has gained a singularmomentum in Islamic banking operations in Bangladesh. In order tocontribute more for the economic development of the country andto encourage their customers to have investment accounts in thebanks as well, Islamic banks in Bangladesh should put more of anemphasis on the long-term financing based on mudarabah andmusharakah, which are considered as the chief alternative to riba. Itis thus proposed that Islamic banks in Bangladesh try to incorporatethe principles of the PLS mechanism in their current investment deci-sion and increase the PLS ratio in total investment through imple-menting special clientele and project-development programs on anurgent basis.

Islamic banks depend to a great extent on religious commitments ofdepositors to maintain their market share rather than competitive andwidespread services. Since the majority of depositors in Bangladeshare from low-income groups, Islamic banks should seek to attractmore customers through extending a wide range of credit facilitiesand realizing high returns on investment deposit so as to avoidendangering their market share. In other words, Islamic banks shouldbuild their bank-customer relationship on economic rather than reli-gious considerations.

Stringent credit policy followed by the Bangladesh Bank needs to bemade more flexible so that the banks can direct more finance to cer-tain economic sectors or activities in line with the objectives of thedevelopment plan of the country. There can be no doubt that thedevelopment goals adopted by Islamic banks in Bangladesh coincidewith the needs of the national economy and help accelerate itsgrowth. Islamic banks can extend finance to small investors, produc-ers, craftsmen, fishermen, and small industrialists, particularly thosein rural areas. Because of the character of the liability side of Islamicbanks, they are capable of financing investment projects of a long-term nature.

To reach desired levels of efficiency, Islamic banks in Bangladeshshould find more standardized financial instruments and innovationsin accordance with the Shariah principles, which will enable them todeal with other interest-based conventional banks. Likewise, Islamicbanks should have their own interbank money markets and develop asecondary financial market for Islamic financial products if they wish

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Islamic banksshould buildtheir bank-cus-tomer relation-ship on eco-nomic ratherthan religiousconsiderations.

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to achieve a true comparison with their conventional counterparts.They must also develop more transparency in financial reporting,auditing, and accounting.

In order to achieve their goals, Islamic banks in Bangladesh areexpected to increase the rate of savings by attracting into the bankingsystem new savers who refuse to deposit their funds with interest-based conventional banks. They are also expected to pay particularattention to the fundamental attitudes of small savers who have beenneglected by their conventional counterparts. Furthermore, it isintended that Islamic banks design an informative program on sav-ings that stresses the development of financial habits and under-standing the benefits that occur from savings.

Finally, Islamic banks still do not have the legal support of the cen-tral bank of the country, which exposes them to great risks. There-fore, it is suggested that Islamic banks in Bangladesh should havetheir own banking act that can provide legal support to the banks andtheir customers..

NOTES

1. With the promulgation of the Bangladesh Bank (Nationalisation) Order 1972, all branchesof the then-commercial banks of the country were classified under six nationalized commercialbanks (NCBs)—Sonali Bank, Janata Bank, Agrani Bank, Pubali Bank, Rupali Bank, and UttaraBank. Since then. the Pubali, Rupali, and Uttara Banks have been put in the private sector andhave been functioning as private banks from November 5, 1996.2. Bangladesh Bank Web site (www.bangladesh-bank.org)3. Bangladesh Bank (1999).4. Islami Bank Bangladesh Limited (2003, p. 53).5. Bangladesh Bank Web site (www.bangladesh-bank.org)6. All scheduled banks in Bangladesh have to maintain their Statutory Cash Reserve and Liq-uidity Reserve with Bangladesh Bank in terms of Sections 25 and 33, respectively, of the BankCompanies Act 1991 (Act No. 14 of 1991). 7. Ministry of Law, Justice, and Parliamentary Affairs (1991) 8. National Board of Revenue (1984), Section 29, Clauses III and IV.9. The acronym CAMEL stands for capital, assets, management, earnings, and liquidity. It is ameasure of the relative soundness of a bank and is calculated on a 1–5 scale, with 1 being astrong performance.10. Bangladesh Bank (1997).11. International Association of Islamic Banks (IAIB) (2001).

REFERENCES

Ahmad, A. (1993). Contemporary practices of Islamic financing techniques. Research PaperNumber 20, First Edition. Jeddah, Saudi Arabia: IRTI.Ahmad, A. (1995). The evaluation of Islamic banking. In Encyclopedia of Islamic banking (p.17). London: Institute of Islamic Banking and Insurance.

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