Commercial Banking

Islamic Bank
Vs
Conventional Bank
 Functions of Commercial
Banks
Commercial banks are
intermediaries which channel the
savings of households,
corporations and governments into
investments and loans.
Two basic functions are ;
1. Accepting the money as deposits
2. Investing or giving loan
Primary functions
Checking, savings and money market
accounts
Time deposits
Loans
Conventional banks provide these
functions
based on interest, but Islamic bank
provides
same functions based on PLS (Profit and
Loss sharing). Risk shared by both
parties.
Secondary functions
Agency functions such
Collects and pays checks, dividends, interest income,
interest charges, rents and insurance premiums.
Purchases stock, bonds according to the customer
requirements.
Correspond with other bank on behalf of the
customer.
Utility functions
Safe-deposit boxes
Travelers' checks
Letter of credit/ trade financing
Credit cards
Trade information and data services.
Structure of a Commercial
Bank
Stockholders
Board of directors
Audit committee
Top level management such CEO.
Operational level management
- Compliance department
- Risk management department
Business segments
- Retail(Consumer) banking
- Corporate banking
- Investment banking
- Treasury
- Trade finance
Investment banking helps the customers to
raise the funds in the capital market and advising
on mergers and acquisitions, leveraged finance
etc.
Treasury helps the banks cash flow by in
borrowing and lending. Treasury operations
include Asset liability management, sales and
trading.
Corporate banking Target corporate and HNW
customer by providing services such as foreign
exchange, cash management, trade finance and
custody etc.
Retail (consumer) banking Target mass
consumer by fulfilling day to day needs and
requirements.
Trade finance by providing the trade financing
to international business of the corporations.
Structure of Islamic Commercial
Banks
Islamic commercial banks have some structure as
conventional
commercial bank, but have two division which is
responsible to
make sure the bank is acting according to the sharia
governance.
Sharia board : compromise of sharia scholars
responsible for issuing fatwa on new products or
operations of the business
Sharia committee supervise the operations of the
Islamic banks and reporting to the sharia board. This
unit make sure the Islamic banks act according to
the sharai principles. Basically this unit do a sharia
audit.
 Difference between Islamic banks and
conventional banks
Conventional bank Islamic bank
Deposit - Guaranteed return -Return not
with predetermined guaranteed and based
rates on PLS
- Guaranteed capital - Only current account
can be guaranteed,
saving or investment
not guaranteed
Money Priced based on TIME Money cannot be
VALUE OF MONEY priced.
concept.
Relationship between Debtor - Creditor Investor, trader,
the customer and partner, lesser, lessee
banks
Transactions Based on financial Based on real assets
assets
Penalty or additional Can be charged based Cannot charge, but
charges for late on interest there are provision for
payment or defaulter charging penalty but
 Part II
Banking
Operations
Islamic Banking
Operations
Sources of Utilization of
funds funds
Stockholders capital and reserves Short term financing
- Murabaha
- Salam
- Qard Hassan
Islamic debt instruments
Interbank borrowings
Deposits/Investment Account
- Ijara
-Istisna
- Mudaraba
- Musharaka

Islamic trade finance

and
Islamic retail finance
 Sources of Funds
1. Deposits, Saving and Investment Accounts
Funds can be generated from Retail funding or
Wholesale funding

Retail funding refers to the retail customer

who are
made up general public and small and
medium
enterprises.

Wholesale funding refers to the HNW

customers,
government, large corporations and other
 Deposits are accepted by Islamic
Commercial banks can be categorized
as follows;
Current Account
The following three Islamic contracts apply to operate current
account in Islamic banks
Deposit (Wadia): In this types contracts, some one gives
property to a trustee for safety reasons and does not expect to
receive any return for the use. In this contract the trustee is
allowed to use the property and should returned when required
by the owner.
Trust deposit (amana) : in the amana contract the trustee just
hold the property and cannot use it.
Difference between both in Islamic bank, if it is amana contract
the bank might charge a fee for service, but in wadia contract no
fee is charged.
Profit-free loan(qard hassan) : qard hassa is a interest free
loan given by lender to the borrow. In current account the
depositor is considered as lender and bank as the borrower.
Savings account
Typically the savings accounts
offered based on mudaraba,
musharaka basis. The customers
are offered return based on PLS.
Some banks takes savings
accounts are wadia or amana,
not giving any return. But may
offer return as gift. (Heba).
Investment Account
Islamic banks offered as conventional banks investment
account with fixed maturity period but based on PLS.
Mostly this accounts are operated based on Mudaraba
contract. Some operates based on wakala contact also.
There are two types of investment accounts
Unrestricted Investment Account (ULA)

In this account the bank as mudarib has complete

freedom to invest the money in the business or project
based PLS.
Restricted Investment Account (RIA)

In this account the investor select the business or

project in which his/her money to be invested. He/she
will only share the PL from that investment.
Islamic Debt Instruments
Islamic banks use debt instruments to fund
short and long term liquidity requirements.
Most commonly used to instruments;
Corporate Sukuk : Islamic version of
conventional bonds
Term financing certificates : Different from
sukuk. Because the certificate holder may
redeem the principle during anytime of the
contract rather than waiting for maturity.
E.g. : Malaysian Islamic banks issued
Negotiable Islamic debt certificate(NIDC). This
instruments is based on bay bithaman ajil).
Interbank borrowings
Islamic banks fund the liquidity requirement
through other Islamic banks. The banks with
excess money lend to the bank with deficit. Mostly
these borrowings are one week or less. Interbank
borrowing are done using Islamic contract.
Following contracts are used to construct inter
bank borrowing between Islamic banks
Mudaraba : based on PLS sharing ratio.
Commodity murabaha deposit
Musharaka : Lending bank as investor and silent
partner and borrowing bank as working partner.
Wakala : Islamic bank with excess liquidity invest
the money using Islamic bank who is in deficit as
representative for their investment.
Utilization of Funds
Islamic banks utilize the fund in the
followings ways
Cash : to manage the liquidity.
Fixed asset : run the operations of the bank
Community service : an amount of money
is reserved for community service. E.g..
Islamic banks fund to micro financing using
qard al hasan loan. Islamic bank also use
zakath and charity fund for this purposes.
Financial instruments : Income generating
financial instruments
Utilization of Funds Financial
Instruments
Equity Financing
(Mudaraba, Musharka)

Asset Based Financing

(Murabaha, Ijarah)

Trade Financing
(Murabaha, Musharaka, Wakala)

Property Financing
(Musharaka, Ijarah, Murabaha)

Corporate Finance
(Murabaha, Mudaraba, Istisna)

Overdraft (Murabaha)

Credit card/personal finance (Qard,Tawaruqq)

 Part III
General Risk and Unique
risks faced by Islamic
financial instruments
Generic Risk
Credit Risk
- Potential risk because of the banks
counter
party debtor/obligator fail to meet the
financial obligation previously agreed.
Credit risk can occur in two ways
a. Involuntary default : obligator looses
the ability repay.
b. Strategic default : deliberate default.
Cost of collection exceeds the loan.
 Risk mitigation for Credit
risk
Ability to repay/credit approvals : before
financing the Islamic banks should ensure that
the counterparty has capacity or ability to
repay the loan. For example analyzing the
financial statement of the obligator before
granting the financing.
Asset collateral/Security : Islamic bank should
ensure the obligator has sufficient collateral in
case defaulting.
Credit history reports
Charity penalty clause : In case of delay in the
settlement, a clause need to be made, which
states that incase of delay a fair penalty need
to be charged and this need to be transferred
to the charity fund.
Market Risk
This risk occurs because of the
adverse movements in the bench
mark rates, commodity or equity
price and foreign exchange rate.
Market risk also refers to the
fluctuation in the fair value of the
asset purchased in order to sell to
the counterparty.
Risk mitigation may change depend
upon the contract.
Liquidity risk
Failure to meet the obligation
when they are due.
The bank perform their financial
obligation through their liquid
asset. When the banks have few
liquid asst and when the dues are
reaching it may fail to satisfy this
dues.
Risk mitigation for liquidity risk
can be different depend upon the
Operational Risk
Operational risk arises when
there are adverse effects in the
business arises because of
failures in technology, people,
internal control or legal and
regulatory environment.
Operational risk also need to be
mitigated depend on the financial
instruments.
Unique risk to Islamic
banks
Equity investment risk : Equity
risk arise because of potential
decline in the fair value of equity
position held by Islamic banks.
Displaced Commercial risk : Since
Islamic banks are operating based
PLS, even if there is loss, they are
forced to give profit to their
depositor. Islamic banks mitigate
the displaced commercial risk in
the followings ways;
1. Bank gives up its portion of its
own profit.
2. Profit Equalization Reserve(PER) :
Profit set a side to when
investment returns low.
3. Investment Risk Reserve (IRR) :
To cover investment loss
Sharia compliance risk : Risk
arise because of non sharia
complaint activities of the Islamic
banks.