Islamic Banking in Indonesia: New Perspectives on Monetary and Financial Issues

By Rifki Ismal

A comprehensive overview of key developments in Islamic banking

In Islamic Banking in Indonesia, renowned economist Dr. Rifki Ismal explores current issues in Islamic banking and financial products with a particular focus on the danger of liquidity risk in Indonesia. It approaches liquidity risk from the conventional perspective of international banking standards, as well as from the Islamic banking perspective. Dr. Ismal also covers the issues of asset-liability balancing, liquidity risk index, organizational structures for managing liquidity, industrial analysis, withdrawal risk, bankruptcy risk, moral hazard risk, and market risk.

Compiling all the latest academic research on liquidity risk and other risks in Islamic banking, the book provides a theoretical foundation for managing risk that will is highly useful for researchers on Islamic banking and practitioners and academics.

• Written by a renowned expert on Islamic banking who works on monetary policy at the central bank of Indonesia
• Covers the latest developments in Islamic banking, particularly liquidity risk, for a rapidly expanding market
• Ideal for European and American readers, in addition to Asian readers, who need a fuller understanding of Islamic banking institutions, markets, and products

With the latest academic research and the expertise of a leading practitioner in Islamic banking, this book offers in-depth coverage of the most pressing issues in the field.

• Language: English
• Publisher: Wiley
• Release date: Feb 22, 2013
• ISBN: 9781118509951

Book preview

Chapter 1

Classic Arab Financial Contracts in Modern Financial Institutions∗

INTRODUCTION

As a way of life, Islam provides not only religious values related to worshipping God and kindness to humankind but also an economic system through special religious contracts (Sharia jurisprudence). Historically, these contracts began in the Prophet Muhammad’s (pbuh) era, when he first introduced Islamic values and concepts of economics and trade to Arab people. Later, such Islamic economic concepts become the basis for modern financial contracts in Islamic financial institutions.

Actually, Sharia financial contracts are composed of some traditional (classic) Arabic economic contracts approved by the Prophet (pbuh) and some other contracts (new contracts) introduced and applied by the Prophet (pbuh) and his companions. By transforming positive aspects of classical Arab contracts and new Islamic contracts, the Prophet (pbuh) had successfully developed fair economic transactions and ensured a stronger economic condition for Arabic society.

ECONOMIC CONDITIONS IN THE PROPHET MUHAMMAD’S (pbuh) ERA

In the Prophet’s (pbuh) era, the Arab economy was trade-based, with no natural resources business. Trading activities were conducted internally and externally with other regions. As such, there were typically several trade links in the Middle East regions such as from Rome into India (southern trade link), Rome into Persia (northern trade link), and Syria into Yemen (northern and southern trade links) (Muhammad 2002, 142). Through these links, Arabic traders gained regional economic advantages by becoming intermediaries for goods delivered from and passing through their regions.

The economic transactions in that time used dinar and dirham as legal currencies, which had stable values for a long period.¹ In addition, the position of Ka’bah as a central, sacred place for all Moslems guaranteed the safety of economic activities of Arabic traders.² In addition, the Hilf ul Fudul agreement among Arab tribes to set up a peaceful business environment (wars among tribes commonly occurred) created the necessary social conditions for trading (Ayati, as cited in Muhammad 2002, 144).

Nonetheless, despite such favorable conditions, some unfair trading contracts existed among traders before the Islamic period. Particularly, unfair and disputable transactions such as Talaqqi Rukban, Kali bi kali, and Riba al Jahiliah³ were common trading activities. Talaqqi Rukban was a practice of stopping foreign traders before they came into the Arabic region, buying their goods, and reselling them with a higher price margin. It was such a traditional practice of price distortion at that time.

Kali bi kali was a transaction in which the buyer ordered a good from the seller to be delivered later with an installment payment basis. Usually, both of the parties (buyer and seller) used borrowed money to fulfill these contracts. Even before the good was delivered by the seller, the buyer had contracted with a third party to be the next buyer of the ordered good. Selling an invisible (not existing) good is prohibited in Islam and the problem is exacerbated if the parties involved use borrowed moneys.

The last practice mentioned is Riba al Jahiliah. In fact, the most dominant mode of financing during the pre-Islamic era was Riba-based borrowing. Riba al Jahiliah was practiced among members of Quraish and Thaqif tribes and in Jewish communities (Kahf and Khan 1992, 11). In this case, a lender made money available to others for a certain period of time with or without any agreement to ask for any profit/remuneration from the borrower. However, when the borrower failed to return the loan in an agreed date, he would be charged interest (for example, 12 percent per annum). The same case applied if the borrowers asked for an extension to repay the loan. But, if the amount was returned on time, there was no charge. This type of hazardous loan is also not allowed in Islam.

Despite the prohibited economic transactions described here, there were other traditional Arab contracts that were fair and respectable trading contracts. Interestingly, those contracts were practiced long before the introduction of Islamic trading values and principles by the Prophet (pbuh). These contracts include Mudarabah and Musharakah, which became part of the modern Islamic modes of financing.

Core Economic Values and Principles

Before elaborating some classic Arab economic contracts, this subsection emphasizes the importance of Islamic values and principles in conducting business. Such values characterize and differentiate Islamic contracts from the conventional ones. As such, understanding Islam as a religion with multiple purposes for society, and Islamic business values and principle in particular, is imperative to the study of Islamic contracts.

Islam as characterized by the Prophet (pbuh) has three grand rules that govern the life of a Moslem as an individual and a member of Arabic society. The first rule is the core relationship between a man and the Creator (Aqidah). The relationship deals with all matters and beliefs of a Moslem. The second rule is the transformation and manifestation of Aqidah to actions known as Sharia. Lastly is Akhlaq, which is the behavior, attitude, and work ethics of a man (see Figure 1.1).

FIGURE 1.1 Islamic Framework on Economic Contracts

Source: Syafii Antonio, Sharia Bank for Bankers and Practitioners (Jakarta, Indonesia: Bank Indonesia and Tazkia Institute, 1999).

Sharia, which is the root of Islamic economic contracts, is composed of two components: (1) rituals (Ibadat), by which the way people worship their God, and (2) business transactions (Muamalat), by which the way people interact with others in terms of economic and noneconomic activities (Antonio 1999, 10–20). The former is principally unchangeable but the latter is changeable, subject to certain economic conditions and development.

Thus, all Islamic economic contracts are derived from the framework of an Islamic system specifically through the Sharia-Muamalat channel. In Islam, such Islamic contracts must be part of a man’s obedience toward and worship of his Creator. Abuse of Allah SWT guidance in Muamalat means insubordination of Islam as the sole guide in Moslem life. Moreover, these principles should also be reflected in one’s contribution to the welfare of the society and people (Ummah) in general. The fairness and mutual economic benefit of business transactions with other parties are among Islamic Muamalat values that have to be implemented in this regard. Other Islamic values pertain to trustworthy mutual support, risk sharing, and prohibition of defeating other parties, as found in the Holy Quran, Sura 26, verses 181–183:

Give a full measure and be not of those who diminish. (26:181)

And weigh (things) with a right balance. (26:182)

And do not wrong men of their things, and do not act corruptly in the earth, making mischief. (26:183)

By expressing Islamic principles and values in business that were not recognized in the pre-Islamic era, the Prophet Muhammad (pbuh) changed the Arabic people’s mindset during and after his era from pursuing unethical business practices to applying fully ethical business principles. Specifically, he (pbuh) used divine law (Quran) and his judgments (Sunnah) to teach Islamic values and principles in Mualamat to people. Besides Quran and Hadith,⁴ there were Ijtihad, Ijma, Qiyas, and some other sources of Islamic law that referred to the guidance of the Prophet (pbuh), his companions, and Islamic scholars. At the end, the business practices together with the application of Islamic law ensured happiness and prosperity for Arabic people that have lasted until the present time.

Meanwhile, with regard to honoring business contracts, Islam asks Moslems to honor property rights and obligations, individual obligations, rights and self-interest, working hard, wealth, the concept of blessing (Barakah), and competition and cooperation (Iqal and Mirakhor 2007, 13). The most important one is property rights, which explains that the ultimate owner of all properties is Allah SWT. A man is only His vice regent and is given the right of possession and utilization of wealth. The other essential things are the principles of risk sharing, competition, and cooperation, which became the basis for almost all Islamic economic contracts, especially those related to investment activities.

Finally, referring to the Hadist (Sunnah) of the Prophet (pbuh):

You know more about your own world. (Hadith narrated by Muslim)

Islam adopts legal maxims that allow any business contract unless there is prohibition on it. Particularly, Islam prohibits economic contracts containing Riba, Gharar, Maysir, Qimar, and hoarding of money. At the same time, Islam encourages positive business activities that utilize money to develop the real sector, including paying Zakah (Islamic levy) and giving Qard Hassan (benevolent loan).

Classical Arab Economic Contracts

The first, and a very well-known, contract is Mudarabah. The Prophet (pbuh) used this himself when he was a trader in partnership with Khadijah, who later became his lovely wife. He was a trader for more than 15 years before the beginning of the revelation. The citizens of Mecca had adopted the Mudarabah contract as their common business contract for a long time. Thus, the legal ruling of Mudarabah in the modern Islamic financial institutions is Sunnah of the Prophet (pbuh), which says:

Three (things) have blessings: Sale of credit, Muqaradah (Mudarabah) and mixing wheat with barley for home not for sale. (Hadith narrated by Ibn Majjah)

Technically, a Mudarabah contract was a form of partnership where one party provided funds while the other party provided skill (expertise) and management. The former was called Shohibul Maal and the latter was named Mudarib. Any profit accrued in this business commitment was shared between the two parties on an agreed-upon basis, while loss was borne by the provider of funds. In the case of the Prophet (pbuh), he (pbuh) became the Mudarib whilst Khadijah was the Shohibul Maal. With his outstanding entrepreneurship skill, Muhammad (pbuh) successfully generated a lot of profit for Khadijah’s business.

Similar to Mudarabah, the second transaction is named Musharakah. However, unlike Mudarabah, in Musharakah the relationship was established under a contract by the mutual consent of the parties to share both profit and loss in a joint business. It was an agreement in which one party provided funds to be mixed with funds from other party (business enterprises) in order to perform joint business financing. All providers of capital were entitled to participate in the management, but were not necessarily required to do so. The accrued profit was distributed among partners in agreed-upon ratios, while the loss was also borne by all partners in proportion to their respective capital contributions.

Besides investment-based contracts, Arab people in Medina used to practice crop-sharing, which was called Muzara’ah and Musaqah. The former was applied to an open field used for crops and the latter referred to an orchard, especially of palm trees (Kahf and Khan 1992, 12). A field in Muzara’ah and both field and trees in Musaqah were fixed assets put at the disposal of the working partners. Both of these contracts required sharing of the gross outputs and were allowed for limited flexibility in the contractual distribution of operational expenses.

Meanwhile, a classical Arab period also recognized a sale of goods on credit, namely Murabahah, which continues to be the favorite contract in today’s Islamic financial institutions. There were many sayings about the Prophet’s (pbuh) buying a good on credit, taking a loan, and sometimes giving a personal property as a security or lien (Kahf and Khan 1992, 12).⁵ By definition, Murabahah stood for a sale of good for a mutually agreed-upon profit and on a deferred payment basis. In this contract, the seller is obliged to declare his cost and profit to the buyer (a practice now called transparency).

Another form of buying and selling a contract was a Salam contract, as reported by Al Bukhari from Al Bara’ bin ‘Azib:

(When) The Prophet came (to Al Madinah) we used to do Salam contracts against cash payment until the season. (Hadith narrated by Bukhari)

Salam was a contract in which an advance payment was made for a good (agriculture good) to be delivered at a future time. In this case, the seller promised to supply a specific good to the buyer at a future date in exchange for an advance price fully paid at the time of the contract assignment. Therefore, Salam provided funds for producers to be used for working capital, labor, and raw materials. Nevertheless, this deferred selling contract could not be applied to a monetary unit (such as gold or silver Salam) because it was judged as Riba al Fadl.⁶ The Prophet mentioned that gold and silver could be exchanged on the spot basis per se. The same rule was applied to other food items known as Ribawi items.⁷

Besides the buying and selling contracts described earlier, the period of the Prophet (pbuh) also recognized Qard Hassan (a benevolent loan). The Prophet (pbuh) said that:

Whoever gave two loans would have a reward (equivalent to the reward) of one of them (be it given as charity). (Hadith narrated by Ibn Majjah).

Qard Hassan meant to give anything valuable to the other parties so that the receiver could benefit from it. However, Qard Hassan was to be paid back on demand or at the settled time. It was typically an honorable loan for temporarily helping others or for charity purposes, as it was released for a certain time with an obligation to repay it within a specified time. Classic Arab contracts also documented Ijarah, which was approximately the same as present-day conventional leasing. However, unlike leasing, the lessor in Ijarah must own the leasing asset and bear all related costs before it was leased to the lessee. In addition, there was no penalty for a late rental payment.

Finally, there was a Wadiah (suretyship) contract, which was typically implemented among people in the Prophet (pbuh) era. The people in Mecca tended to put their items (Wadiah items) to the Prophet (pbuh) under Wadiah commitment without any guarantee from him as a depository. Before moving to Madinah, Muhammad SAW asked his companion Ali bin Abi Thalib to return those Wadiah items to the owners. Regarding this, there was another report from the Prophet’s (pbuh) companion Zubair. He used to encourage his depositors to consider placing Wadiah items with him in safekeeping, rather than as a deposit. A safekeeping contract guaranteed that the funds would be returned and gave more flexibility to the keeper to use it.

DEVELOPMENT OF CLASSIC ECONOMIC CONTRACTS

For the past three decades, there has been a strong effort by Moslems to apply those classic and traditional Arab economic contracts in the modern economic/financial transactions, particularly in Islamic banking. The year 1963 was notable for the first establishment of a modern Islamic banking institution, namely Mit Ghamr Bank, in Egypt. Mit Ghamr provided funds for agricultural investment. Later on, triggered by at least three factors—(1) the establishment of the Islamic Development Bank (IDB) in 1975, (2) the world oil-price hike in 1973 to 1974, and (3) the increased role of Moslem scholars in the past three decades—Islamic banks became a new phenomenon in today’s financial system (Wilson 2006, 2).

IDB was established as a result of the Organization of Islamic countries (OIC) finance ministers’ agreement in December 1973. Through IDB and some earlier Islamic banks in the Gulf and Malaysia such as Dubai Islamic Bank, Faisal Islamic Bank, Al Barakah Bank and Bank Islam Malaysia Berhad, the classic Arab economic contracts were modernized and designed to suit the modern financial practices. In today’s Islamic banking instruments, such classic contracts are grouped into equity contracts such as Mudarabah, Musharakah, Musaqah, Muzara’ah; debt contracts such as Murabahah and Salam; and other contracts such as Ijarah, Qard Hassan, and Wakalah.

However, the second factor facilitated the development of modern Islamic banking institutions worldwide due to the massive increase of the financial resources of the major Gulf countries. Pioneers of modern Islamic banks were founded in that decade, such as Dubai Islamic Bank (1975), Kuwait Finance House (1977), Bahrain Islamic Bank (1981), Qatar Islamic Bank (1983), and Faisal Islamic Banks of Egypt and the Sudan in 1977 and 1978 respectively.

The last factor is the increased role of Islamic scholars worldwide who promote the ideals of Islamic financing, format the Sharia compliance contracts, and supervise the operations of Islamic banks. They emphatically support the development of modern Islamic banking institutions, especially to interpret and modify such classic contracts to comply with up-to-date product requirements. Currently, there are around 150 world Islamic scholars employed by hundreds of Islamic banks in more than 75 countries (Dar 2006, 1). Nonetheless, among 150 Islamic scholars, only 20 of them are internationally recognized.

Application of the Contracts in the Modern Islamic Banks

Undoubtedly, after the establishment of the first Islamic bank, the strong support from various international Islamic institutions and Islamic scholars, the classic Arab economic contracts in the era of the Prophet (pbuh) and his companions have come into modern Islamic financial applications such as Islamic banks, Islamic insurance, Islamic multifinance, Islamic securities companies, and so forth. However, due to some requirements and challenges in modern financial practices and public perceptions of Islamic banking institutions, the classic contracts need to be modified and adjusted to be applicable and acceptable. Such modifications are done under Sharia justification and Sharia scholars’ approval. Some examples are explained in this chapter, namely Mudarabah, Musharakah, Muzaraah, Musaqah, Murabahah, Wadiah, Ijarah, Qard Hassan, and Salam.

Mudarabah Contract

On the liability side of an Islamic bank, Mudarabah is formatted as a time deposit (commonly known as a Mudarabah time deposit) and on the asset side it is used in the form of Mudarabah financing between a bank and its business borrowers. Contemporary Islamic banking theory classifies Mudarabah as equity-based deposit/financing because of its investment characteristics. Technically, both the Mudarabah time deposit and Mudarabah financing are arranged under a profit-and-loss sharing (PLS) mechanism as drafted in Figure 1.2 (Obaidullah 2005, 58).

FIGURE 1.2 Two-Tier Mudarabah Financing Structure

Source: Mohammed Obaidullah, Islamic Financial Services. Islamic Economic and Research Center, King Abdulaziz University, Jeddah, Saudi Arabia, 2005.

First, the depositors place some funds in the Mudarabah time deposits, called Shohibul Maal. The Islamic bank functions as a Mudarib (step 1). The bank then invests the funds in Islamic projects proposed by entrepreneurs who express strong cooperation and commitment (steps 2 to 3). However in this step, the bank positions itself as a Shohibul Maal, or the supplier of the funds, and the entrepreneur is a Mudarib. When the Islamic projects produce profit, it will be shared between the bank and the entrepreneurs, and finally the bank’s share is also shared with the original Mudarabah time depositors (step 4). However, if loss occurs it will be borne by the depositors through the decreasing value of their funds (step 5). This popular mechanism in contemporary Islamic banking contract is called a "two-tier Mudarabah contract."

Musharakah Contract

A Musharakah contract resembles a Mudarabah application in an Islamic bank, as it is the second form of equity-based financing. Nevertheless, unlike Mudarabah, Musharakah requires the contribution of funds of all parties involved in the business. In modern Islamic banking practices, a Musharakah contract is usually found only on the asset side of the bank. As drafted in Figure 1.3, after depositors deposit funds in the bank deposits (step 1), under Musharakah financing contract, an Islamic bank and its borrowers/entrepreneurs mix their funds together in order to finance an agreed-upon Islamic project for a certain period of time (step 2). Both of them also have a right to contribute to the management of the project.

FIGURE 1.3 Musharakah Financing Structure

Source: Based on Mohammed Obaidullah, Islamic Financial Services. Islamic Economic and Research Center, King Abdulaziz University, Jeddah, 2005.

The same as in a Mudarabah financing contract, if a Musharakah project generates profit, it belongs to both parties according to the agreed-upon ratio (step 3). But, if it suffers a loss, it will be shared in proportion to the capital contribution of each party. As such, loss effectively brings down the value of the business assets of each partner but keeps the shares of each partner unchanged (step 4).

Second, in Musharakah all parties (business partners) behave as both Shohibul Maal and Mudarib; there is no single Mudarib or Shohibul Maal. The feature of the classic Mudarabah and Musharakah contracts requires that either of the parties have an option to terminate the agreement or quit from the venture at any time they want. In the termination date, profits are determined as excess of the liquidated values of all assets. However, instead of terminating the investment, the continuity of the business is the priority for all partners.

Muzaraah and Musaqah Contracts

Unfortunately, most modern Islamic banks rarely employ Muzaraah and Musaqah in their financing activities. This is because banking institutions (Islamic or conventional banks) position themselves as financial intermediaries. They prefer providing funds over retaining assets, including land, for example. As such, the modern banks simply finance a project and conduct business monitoring, evaluation, and cooperation with entrepreneurs. Owning an asset (land or farm) incurs extra costs and risks for banks, such as maintenance costs, product risks, market risks, and so forth. However, to improve the agriculture sector, intensifying both Muzaraah and Musaqah is one of the best options available to Islamic banks.

Murabahah Contract

Modern Islamic banks use Murabahah on the asset side. This is the most popular kind of contract, as shown by the domination of such contracts in the composition of banks’ financing. In contemporary Islamic finance, Murabahah is categorized as debt-based financing. The one-tier Murabahah contract in the Arab period is changed and adjusted to be the two-tier Murabahah contract. Hence, Islamic banks function as financing providers to clients who want to purchase and own an asset (house, car, etc.).

A Murabahah contract is illustrated in Figure 1.4. First, the client approaches the vendor (owner of the asset) regarding the asset that he wants to buy (step 1a). At the same time, he also approaches an Islamic bank to be his financial provider to acquire the asset (step 1b). After signing a Murabahah contract, an Islamic bank then purchases the asset from the vendor and sells it to the client with mark-up (based on a Murabahah margin, agreed upon bilaterally) (steps 2 and 3). Finally, the client will pay the price of the asset (principal amount plus mark-up) in full or by installments within a certain time period (step 4).

FIGURE 1.4 Murabahah Financing Structure

Source: Based on Mohammed Obaidullah, Islamic Financial Services. Islamic Economic and Research Center, King Abdulaziz University, Jeddah, Saudi Arabia, 2005.

Salam Contract

As one of the debt-based contracts, a Salam contract popularly lies on an Islamic bank’s asset side. Salam was originally designed as a financing mechanism for small farmers and traders. Nonetheless, in modern Islamic banks, Salam still functions mainly to finance agriculture or trade activities as mentioned previously, but it is again modified due to the bank’s core functions as a financial intermediary (see Figure 1.5).

FIGURE 1.5 Salam Financing Structure

Source: Based on Mohammed Obaidullah, Islamic Financial Services. Islamic Economic and Research Center, King Abdulaziz University, Jeddah, Saudi Arabia, 2005.

With a Salam contract, an Islamic bank buys (orders) a specific good from a producer (farmer) to be delivered on a future (specified) date. On the other hand, the producer in need of short-term funds sells the good to the bank on a deferred delivery basis (step 1a). However, unlike Murabahah where the good already exists and is directly given on the spot to the buyer, the Salam producer receives full price in advance without any delivery of the good in the same time (step 1b). On the agreed-upon future date, the producer delivers the specified good to the bank (step 2). Finally, the Islamic bank sells the good to the market at the prevailing price. Since the spot price that the bank pays is pegged lower than the expected future price, the transaction should result in a profit for the bank (Obaidullah 2005, 95).

Qard Hassan Contract

The use of a Qard Hassan contract in today’s banking operations is seen on both the liability and asset sides of a bank (see Figure 1.6). The liability side is very fortunate to have this classic Arab economic contract, as it matches a modern deposit characteristic, namely, demand deposit. With this deposit, an Islamic bank is free to utilize the Qard Hassan funds at its own risk. Usually such funds are given to an unbankable person or to micro-finance entrepreneurs. The depositors, as the lenders, are not entitled to any return, because any kind of benefit passed to depositors under Qard Hassan is deemed as Riba.

FIGURE 1.6 Qard Hassan Financing Structure

Source: Based on Mohammed Obaidullah, Islamic Financial Services. Islamic Economic and Research Center, King Abdulaziz University, Jeddah, Saudi Arabia, 2005.

On the asset side, an Islamic bank serves its customers with Qard Hassan financing. An Islamic bank is allowed to ask for collateral, as governed by the Fiqh⁸ rules of al-Rahn.⁹ Moreover, to cover the operation of the loan (Qard), the bank can also charge the borrower some administrative expenses (see Figure 1.6). Technically, a Qard Hassan contract begins with the borrower’s approach to the bank for a loan (step 1).

When the bank approves the borrower’s application, it will then advance Qard Hassan funds, in exchange for some collateral and a fee from the borrower to guarantee the contract and replace the administrative costs (step 2). Other than maintenance or operational costs, an Islamic bank is not allowed to charge extra costs in Qard Hassan lending. At the end, in an agreed-upon period, the borrower returns the funds to the bank (step 3).

Ijarah Contract

Historically, the classic Arabic economic contract described Ijarah is a leasing or hiring of a physical asset. At present, it does not make any significant difference. Ijarah is a fashionable debt-based product in which the Islamic bank is the lessor of an asset. Then, the asset is leased by the client (lessee) in an agreed-upon period. Therefore, with an Ijarah contract, an Islamic bank receives the monetary benefits coming from the payment of the rental rate of the leased asset while the lessee gains benefit in the form of usufruct of the asset. The differences between an Islamic Ijarah contract and conventional leasing are:

Ijarah uses a noninterest benchmark in the rental rate but the conventional leasing uses the interest rate for its rental price.

Any risk associated with the Islamic leased asset is the responsibility of the lessor. This is not the case in conventional leasing.

There is no charge in the case of a customer’s default in Ijarah, but there is a penalty or interest charge in conventional leasing; and so forth.

The structure as illustrated in Figure 1.7 begins when the bank’s client proposes that an Islamic bank facilitate his Ijarah contract. The Ijarah contract is due to his plan to use a certain asset owned by a vendor (steps 1a and 1b). After the Ijarah contract has been approved, the bank takes over (buys) the asset from vendor (step 2) and leases it to the client (step 3). The client pays the rental rate until the end of the leasing contract (step 4).

FIGURE 1.7 Ijarah Financing Structure

Source: Obaidullah 2005 (modified).

Wadiah Contract

The same as a Qard Hassan demand deposit, a Wadiah demand deposit essentially provides a safekeeping deposit of the depositors’ funds. Any withdrawal is guaranteed and honored by the bank. Even though safe keeping deposits are free of cost for the banks and depositors, banks can provide additional features for Wadiah depositors. For example, depositors are given easy access to funds through a check facility, automated teller machine (ATM), charge cards, traveler’s checks, telephone banking, branch services, standing instructions, quick statements, a balance enquiry facility, remittances, and so forth.

Practically, Islamic banks classify Wadiah contracts in two forms, namely Wadiah wad Amanah and Wadiah wad Dhamanah. The former guarantees the Wadiah funds, not only the value but also the physical accessibility. The example of a Wadiah wad Amanah product is a safe deposit box facility. However, this guarantees only the value of the funds. Hence, by providing a Wadiah wad Dhamanah service, a bank can utilize the funds at its own risk. Any profit or loss coming from the investment of the Wadiah funds accrues entirely to the bank.

Advantages of Implementing Classic Contracts in the Modern Islamic Banks

With their unique characteristics followed by some modifications, the classic Arabic economic contracts offer several benefits to the modern banking system. Islamic banking serves as an alternative in the world of conventional financial system. Benefits offered by this new banking operation include the following:

The classic Arab economic contracts replace the interest-based system with either trade-based or investment-based system with profit and loss sharing mechanisms.

Islamic banks connect the real sector and financial sector by adopting classic Arabic economic contracts. Speculative banking transactions in the foreign exchange market, money market, or capital market are strictly prohibited in Sharia.

Islamic banks treat all related parties fairly. In fact, based on the profit and loss sharing (PLS) scheme, risk and return is shared among parties involved in the PLS contracts.

The conventional banking mindset of just looking for high profit/return is switched into the social benefit motives by introducing Qard Hassan, Zakat, Infaq, and Shodaqoh, and so forth.

Constraints/Challenges of Implementation

The existing economic and financial environment in some ways restrains the implementation of the Islamic values inherited in the classic Arabic economic contracts. Without ignoring the strong efforts of Islamic scholars, governments, and all stakeholders, the development of the Islamic banking industry still faces some challenges:

The acceptance of the public despite the perception that Islamic banking is still not optimal. In many cases, the public still challenges the tenet of the Islamic banking contracts rooted from the classic Arabic economic contracts, such as prohibition of Riba, profit and loss sharing schemes, and so forth.

The operation of Islamic banking itself is often less effective and efficient compared with its counterpart. The contracts are so bureaucratic and complicated that the cost of acquiring financing from an Islamic bank is often higher than from a conventional one.

In some cases, the modernization and modifications of Islamic banking contracts have invited many critics. Mimicking conventional bank contracts, benchmarking on interest in determining return sharing, and so forth, are some of the critics’ complaints.

CONCLUSION

Moslems have been trying to adapt classic Arab economic contracts for use in modern financial institutions. The establishment of Islamic banks in the past three decades proved the strong effort of religious Moslems to apply Islamic values and principles in business and financial transactions. In fact, some Islamic ideas behind classical Arabic economic contracts have been modified to be applicable in current banking practices. Fortunately, it has introduced fair banking system, eliminated interest, and offered an alternative to the existing banking system. However, for future development, some improvements have to be taken in order to smooth its operations and create a positive impression on the public.

NOTES

1. In that time, the Arab region used both dinar (Rome’s currency) and dirham (Persia’s currency).

2. In a year, there should be four months free of any conflict, war, or pilgrimage activities, to be maintained peacefully.

3. It means an increase over principal in a loan or in exchange for a commodity accrued to the owner (lender) without giving an equivalent countervalue or recompense (‘iwad) in return to the other party.

4. Refers to the Prophet’s custom, habit, or way of life.

5. Aisyah reported that The Prophet (pbuh) bought some food on credit from a Jew and he (The Prophet [pbuh]) gave him (The Jew) his mail (armor iron cloth) as a security (Hadith narrated by Bukhari). Abu Hurairah also said that the Prophet borrowed (once) a male camel.

6. An excess in the exchange of Ribawi goods within a single genus.

7. Goods subject to Fiqh rules on Riba in sales.

8. Islamic law (the science of Sharia). It is an important Islamic source of law for Islamic economics.

9. Pledge or collateral.

REFERENCES

Antonio, Syafii. 1999. Sharia Bank for Bankers and Practitioners. Jakarta: Bank Indonesia and Tazkia Institute.

Ayati, Mohd Ebrahim. 1979. History of the Prophet of Islam. Teheran: Teheran University.

Dar, Humayon. 2006. Banks Seek Islamic Scholars Versed in World of Finance. Dow Jones Reuters Business Interactive LLC, London, United Kingdom.

Iqbal, Zamir, and Abbas Mirakhor. 2007. An Introduction to Islamic Finance: Theory and Practices. Singapore: John Wiley & Sons.

Karim, Adiwarman. 2004. Historical Thought of Islamic Economy. Jakarta: Raja Grafindo Persada.

Kahf, Monzer, and Tariqullah Khan. 1992. Principles of Islamic Financing. Islamic Research and Training Institute, Islamic Development Banks (IDB), Research Paper no. 16.

Ministry of Religion. 2005. The Holy Al-Qur’an. Bandung: Diponegoro.

Muhammad. 2002. Monetary and Fiscal Policy in Islamic Economy. Jakarta: Salemba Emban Patria.

Obaidullah, Mohammed. 2005. Islamic Financial Services. Islamic Economic and Research Center, King Abdulaziz University, Jeddah, Saudi Arabia.

Wilson, Rodney. 2006. Chapter Two: The Evolution of Islamic Financial System. United Kingdom: Institute for Middle Eastern and Islamic Studies, Durham University.

∗The original version of this chapter was published in Al-Liqa Journal (Palestine) 35 (December 2010).

Chapter 2

Program to Develop Indonesian Islamic Banking∗

INTRODUCTION

Similar to most predominantly Moslem countries, Indonesia has a progressive Islamic banking industry that relies on the performance of the real sector. There are some engines of growth that trigger the development of banking, especially the large Moslem population and support from the government, banking regulators, Parliament, and Islamic scholars. However, despite the robust performance of the industry, there are some challenges that face banking in Indonesia. The first challenge is small market share, which limits the operations of Islamic banks, financial market activities, and the contributions of the industry to the economy.

Second is the lack of human resources in a field with a growing demand for highly skilled and well-educated employees. Third is the lack of product development to facilitate various Islamic financial transactions. In fact, Islamic banks in Indonesia mostly employ classic Islamic banking contracts and need more product innovation.

This chapter explains the Indonesian Islamic banking industry. In particular, it discusses the legal aspects, infrastructure, and program of development; engines of growth; performance of the industry; and some challenges to the industry. A program of development is proposed at the end of the chapter, to improve the condition of the industry and the current banking practices, and to advance the prospects of the industry.

THE INDONESIAN ISLAMIC BANKING INDUSTRY

The Indonesian Islamic banking industry started in 1991–1992 when the first Islamic bank was established. Since then, it has developed significantly and is supported by the government, the central bank of Indonesia, Islamic scholars, and the public in general. However, as a new industry compared to the conventional one, it still has some limitations and needs strong efforts to move it forward. The following subsections discuss four aspects of the industry determining its prospects in the future: (1) legal aspects and the operations of Islamic finance, (2) engines of growth, (3) the performance of the industry, and (4) challenges of the industry.

Legal Aspects and the Operations of Islamic Finance

Indonesia has dual banking and monetary systems. This combination was stated formally in the Central Bank Act number 23 of 1999 and was later amended to be act number 3 of 2004. These acts state that the country permits both Islamic and conventional monetary operations (Bank Indonesia 1999). Moreover, the banking act number 7 of 1992, later amended to be act number 10 of 1998, allowed the implementation of Islamic banking alongside conventional banking (Bank Indonesia, 1998). These acts became the fundamental legal foundation for the development of Islamic banking in the country.

In mid-2008, Indonesia enacted important legislation, namely the Islamic banking act number 21 of the year 2008 and the Sukuk act number 19 of the year 2008 (Bank Indonesia 2010a and 2010b). The approval of these Islamic banking acts provides the ideal legal foundation for the application of the Islamic banking industry. In fact, even though the industry has been operating since 1991–1992 when the first Islamic bank was established, there was no special act on Islamic banking until act 21 of the year 2008 was approved. The existence of some Sukuk (corporate and government Sukuk) in the Indonesian capital market has also been facilitated by the approval of the Sukuk act.

In the operations of Islamic finance, Indonesia has had various types of Islamic financial institutions, Islamic financial markets, and supported institutions (see Figure 2.1). Starting from Islamic commercial banks (BUS) that serve all segments of the depositors and entrepreneurs, it also has Islamic banking windows (UUS), which are units in the commercial banks operating with Islamic principles. Further, there are Islamic rural banks (BPRS) that target certain communities in certain areas. BPRS operate regionally, while BUS and UUS operate nationally.

FIGURE 2.1 Infrastructure of Islamic Finance in Indonesia

The Indonesian Islamic finance system also consists of a number of nonbanks: Islamic financial institutions such as multifinances, BMT, and Takaful. There are more than 100,000 BMTs in the country that serve micro entrepreneurs based on an Islamic cooperative approach. However, even though the number of Islamic multifinances and Takaful are not as many as BMTs, they take part to support the application of Islamic finance. Indeed, these Islamic banking and nonbanking institutions absorb public funds and finance both medium and large businesses and small and micro businesses.

The existence of Islamic banking and nonbanking financial institutions is supported by regulators and supporting institutions such as National Sharia Board, the Accounting Association (IAI), the Islamic banking association (ASBISINDO), Zakat institutions such as BAZNAS, and so forth. Moreover, in order to mitigate liquidity problems and to expand investment alternatives, there are the Islamic capital market, the Islamic money market, and the Islamic stock market. Those are the unique operations of the Indonesian Islamic finance.

In order to foster the development of the Islamic banking industry, the central bank (Bank Indonesia) applies a blueprint that consists of six initiative programs to be implemented within 10 years (2005–2015), namely:

1. Increasing Sharia compliance.

2. Increasing the quality of prudential banking operations.

3. Increasing operational efficiency and competitiveness.

4. Increasing the stability of the banking system.

5. Increasing the expertise and quality of human resources.

6. Optimizing the social roles of Islamic banks in developing small and medium enterprises (SME). (Bank Indonesia 2006)

Such a blueprint serves as guidance for banks, banking regulators, government officials, and all related parties in determining the long-term strategies and programs to expand the industry. Further, in order to boost the market share of Islamic banking, Bank Indonesia created grand strategies regarding the development of the Islamic banking industry that are now called market development strategic programs or simply MDSP (Markplus and Bank Indonesia 2008). In particular, MDSP implements six strategies:

1. To position the industry as the most attractive one and the leader among the ASEAN countries in 2009 and 2010 respectively.

2. To create the new image of Islamic banks that are inclusive and universal.

3. To accurately map the Islamic banking potential market.

4. To develop Islamic banking products.

5. To improve banking services.

6. To newly communicate the position of Islamic banks as banking that is beyond banking.

In fact, since the establishment of the first Islamic banks in 1991–1992 and after the implementation of the blueprint, the industry has developed significantly and progressively.

Engines of Growth

There are at least four supporting factors that boost the development of Indonesian Islamic finance. First of all is the large population of Moslems in Indonesia. Based on the national survey taken in 2010, there were at least 208 million Moslems out of a population of 237 million. There is indeed a potential demand for Islamic financial institutions. Moreover, concerning the results of the banking customer surveys done by Bank Indonesia between 2000 and 2009, Mars Company in 2008, and Markplus and Bank Indonesia in 2008, almost all of the people in Indonesia supported the idea of Islamic banks and their counterparts (Markplus and Bank Indonesia 2008). As such, it depends on the ability of Islamic banks to meet the expectation of people to optimally utilize such a potential demand.

Second, support from the banking regulators, Parliament, government, and Sharia scholars also plays a part in developing the Islamic banking industry. Those parties have successfully approved acts to support the operations of Islamic financial institutions. This is very important, as the interaction between domestic Islamic financial institutions and international institutions requires a legal basis. The approval and application of both Islamic banking and Sukuk acts as mentioned previously have triggered and facilitated the advancement of the industry and the Islamic financial markets, as well.

In particular to Bank Indonesia as the banking authority, it has issued various banking regulations to maintain and foster the growth of the industry. The examples are a channeling program in 2007, less capital required to establish a new Islamic bank, and a linkage of the placement of funds in the central bank certificate (SBIS) and reserve requirement. Moreover, to perfectly understand the verdicts of the National Sharia Board (DSN) and the implementation of Islamic banking regulations, Bank Indonesia has set up an Islamic banking committee on November 20, 2008 (Bank Indonesia, 2008). The members are composed of Bank Indonesia’s staff, Islamic scholars from Ministry of Religion, Islamic bankers, and finance experts.

Third, the robust performance of Islamic banks in the past two decades has attracted the public to deposit and become business partners. However, the strong support from the public is a very rational one. They become depositors and business partners of Islamic banks if the banks: (a) pay a competitive return on Islamic deposits and (b) have complete banking facilities and services (Ismal 2009). These conditions require Islamic banks to perform professionally and have a comprehensive program to complete their operations with perfect services and networks.

Fourth, the performance of the Indonesian economy backs up business operations of Islamic banks. The economic growth of 4.5 percent in 2009 was declared as the third highest economic growth in the world after China and India’s economies, and the global financial crisis of 2008 to 2009 did not severely disrupt the Indonesian economy (Bank Indonesia, 2010c). These facts create conducive business environment for banks, including Islamic banks.

Performance of the Islamic Banking Industry

The Indonesian Islamic banking industry grew at a promising rate after the establishment of the first Islamic bank, Bank Muamalat Indonesia (BMI), in 1992. Until the latest data of September 2012, there are 11 Islamic commercial banks (BUS) followed by 24 Islamic banking windows/Unit (UUS) and 156 Islamic rural banks (BPRS) integrating 2,500 offices around the country (see Table 2.1). In the past five years, the industry has been growing at a rate of 38 percent per year, and last year at a rate of 49 percent, while the world growth of the Islamic banking industry was around 10 percent to 20 percent per year (Eedle 2009).

TABLE 2.1 Selected Islamic Banking Performance Indicators∗

Source: Bank Indonesia (2000–2012).

Concerning the banking intermediary function and prudential banking operations, the Islamic banking industry performs a promising intermediary function and offers banking operations. The financing to deposit ratio (FDR), as one of the banking indicators of the banking intermediary function, has been lying on 104 percent on average from December 2000 to September 2012 and the nonperforming financing (NPF) stands between 2 percent and 4 percent of the total financing (Bank Indonesia, 2002–2012). Other indicators, such as total assets, financing, and deposits grow annually between 50 and 60 percent on average per year.

Lately, the total assets have reached Rp168.8 trillion with total financing of Rp130.4 trillion and total deposits of Rp127.8 trillion. The figures are expected to grow further with an acceleration rate between 30 and 50 percent per year. However, the dominant contributor of the capital is the owner’s funds besides retained profit. With this achievement, the future performance of the Islamic banking industry shows great promise, despite some economic challenges, such as the uncertainty of the world economy and direct and indirect effects of the European economic crisis on the Indonesian economy, and the possibility of a downturn in the domestic economy.

Meanwhile, comparing the growth of both Islamic and conventional banks reveals that the Islamic banking industry has higher growth than conventional banking. Particularly, between 2001 and 2004, both the growth of assets and financing of Islamic banks stood at a higher growth rate than conventional ones. However, during the periods of 2005 to 2010, the growth rate of both assets and the financing of Islamic banks had slowed down although it still stood in a higher position than conventional banks (see Figure 2.2). Such a progressive growth is also implied in the upward trend of the Islamic banking market share (see Figure 2.3). Nonetheless, the market share is very small compared with the conventional banks. As of September 2012, the market share was only 4.2 percent of the total banking industry.

FIGURE 2.2 The Growth of Banks’ Assets

Source: Bank Indonesia (2002–2012).

FIGURE 2.3 Market Share of Islamic Banks

Source: Bank Indonesia (2002–2012).

Moreover, unlike the operations of Islamic banks in other countries, the Indonesian Islamic banks consistently increase the share of investment-based financing (Mudarabah and Musharakah contracts). Up into September 2012, such investment-based financing have captured 27 percent of the total financing while the trade-based financing (Murabahah, Salam, and Istishna contracts) dominate 71 percent of total financing (see Figure 2.4). This intention reveals that the operations of Islamic banks approach the ideal model of Islamic banking with the domination of investment-based financing and a minimum of trade-based financing.

FIGURE 2.4 Breakdown of Financing

Source: Bank Indonesia (2002–2012).

In addition, Indonesia does not apply the controversial Sharia contracts such as Bay al Innah, Bay al Wafa, Tawarruq, Bay al Dayn, which dominate the Islamic banking contracts in Malaysia and Middle Eastern countries (Karim, 2006). It means that by applying only classical contracts (noncontroversial contracts), the Indonesian Islamic banking industry can still perform well despite having a small market share. As discussed earlier, the advancement and expansion of this industry in Indonesia depends on the performance of the Islamic banks and economic conditions; it does not rely on the application of controversial contracts (Siregar, 2002).

Meanwhile, if an Islamic bank faces liquidity shortages or surpluses in their operations, they can obtain or extend liquidity from/to the Islamic money market (PUAS). However, unlike the money market activities in the conventional money markets, PUAS activities are not very active because the internal liquidity management is quite robust. The Islamic banks rarely need sudden liquidity from external sources such as PUAS (see Figure 2.5). In addition, Islamic banks concentrate their financing directly to the real sector and do not seek profit by trading Islamic securities in the Islamic financial markets (Ismal 2010).

FIGURE 2.5 Islamic Money Market Activities

Source: Bank Indonesia (2002–2012).

Besides using PUAS, there is another outlet by which to gain or extend funds, namely the central banks’ Islamic monetary instrument (SBIS). But, similar to the placement of funds in the Islamic money markets, locating funds in SBIS is not the primary target of Islamic bank financing (see Figure 2.6). Only 2.6 percent of total financing goes to this Islamic monetary instrument; even when the return of SBIS is up, the placement of funds does not go up as well. On one hand, this shows the ineffectiveness of the Islamic monetary instrument to influence liquidity, but on the other hand, the minimum placement in SBIS also indicates intensive bank financing to the real sector.

FIGURE 2.6 Islamic Monetary Instrument

Source: Bank Indonesia (2002–2012).

Furthermore, despite providing Islamic money-market funds and SBIS, an Islamic bank that looks for new investments or wants to locate funds in long-term investment projects can enter the Islamic capital market. Currently, the market is getting more active after the enactment of the Sukuk Act in 2008. By the mid-2012, total government Sukuk was recorded as Rp23 trillion (US$2.3 billion) and is predicted to keep increasing in the years to come (see Figure 2.7).

FIGURE 2.7 Tradable Government Sukuk

Source: Ministry of Finance (2012).

Challenges of the Industry

However, although the industry presents remarkable performances and liquidity management, it has some challenges to be solved. Amongst others, there are three main challenges. The first challenge is the market share of the Islamic banking industry. It was recorded 4.2 percent at the end of September 2012. There are at least two factors that limit the expansion of this industry: (1) the lack of human resources and (2) the lack of product development.

Regarding the lack of human resources, the promising growth of Islamic banking in the country has not been followed by a increase in educated employees. Per year, the demand for new employees is around 10,000 while the formal institutions (universities, and colleges) can only supply 50 percent of them (Four competencies of Islamic human resources in Islamic banks 2012). The third challenge is the lack of product development. Compared with the Islamic banking industries in Malaysia and Middle Eastern countries, the Indonesian Islamic banks have limited banking products. To some extent, this condition might discourage investors and depositors from engaging in Islamic transactions with Islamic banking.

Small Market Share

After two decades of operations, Islamic banking still holds only a single-digit market share. Some underlying reasons explain this problem such as: (a) the limited involvement of government funds in the Islamic banking industry, (b) the lack of comprehensive understanding among depositors, business partners, and the public with respect to the operations of Islamic banking