WORKING CAPITAL DIFFERENCE BETWEEN ISLAMIC & CONVENTIONAL BANKING SYSTEM.

Submitted to: Saad Hossain Honorable Lecturer North South University

COURSE: FIN 340(7)

SUBMITTED BY: GROUP- ACQUIESCE ISHTIAQUE AHMED CHISHTI MUFRAD MAHMUD CHOWDHURY TARANNUM BASHAR HASIN ABRAR NAFIS M ZAMAN RESHA MOHAIMEN 0910240030 0910654530 0910921030 0910049030 0910263030 0920513030

Date: 18th April, 12

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ABSTRACT: With the establishment of the first Islamic bank "Islami Bank Bangladesh Limited" Islamic banking started as a new paradigm in Bangladesh in 1983. After that, 6 more banks have been established in the country to reach the outcome of this welfare banking to the doorsteps of the people. In the past two decades, it has shown its great robustness in achieving the goal of Islamic Shariah. Observing the success, many conventional banks have been allured to open their own Islamic branches with the traditional ones. For a continued expansion of the Islamic Banking system, however, a number of issues that pose serious problems for Islamic banks has been addressed in the past and still it is sort of an ongoing issue. The growth of Islamic banking in Bangladesh is progressing day by day. The remarkable shift or conversion o f the conventional banks and their branches into Islamic lines gives.

" I N TE R E S T I S A F I X E D R A TE O F R E TU R N O N A L O A N O R A D E P O S I T , A D V A N C E D B Y T HE F I N A N C I E R I R R E S P E C T I V E P R O F I T O R L O S S I S C O N S U M E D B Y T HE D E B T O R . W H E R E A S , M U S HA R A K A H D O E S N O T E X E R C I S E O N F I X E D I N T E R E S T R A T E . B U T S HA R E S T HE P R O F I T E A R N E D O R L O S S I N C U R R E D B Y T H E J O I N T V E N TU R E . T H E F I N A N C I E R D O E S N O T S U F F E R L O S S , W HE R E I N M U S H A R A K A H B O T H T HE F I N A N C I E R A N D D E B T O R S U F F E R T HE L O S S I F TH E V E N TU R E F A I L S T O P R O F I T . I F T H E D E B TO R S U F F E R S A L O S S , I T I S U N J U S T O N P A R T O F TH E C R E D I TO R TO C L A I M A F I X E D R A T E O F R E TU R N . O N T HE O T HE R HA N D T HE D E B T O R E A R N S A V E R Y H I G H R A TE O F P R O F I T , W H I C H I S I N J U S TI C E T O T HE C R E D I T O R T O G I V E A S M A L L P E R C E N T O F T HE P R O F I T L E A V I N G T H E HI G H E R F O R T HE D E B T O R . "

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Though our intension was to bring Musharakah system in this paper, according to which(Musharakah) profits and losses are distributed among both the financier and debtor, we also added some other issues that make a clear senesce in the mind of reader about Islamic Finance System and shock absorbing characteristics of Islamic financing. This paper also discusses the differences in ways Islamic bank and other conventional banks manage their working capital along with an overview of how they operate their activities. We also tried to bring the insight of Islamic Banks policy of dealing with bad debts , allocation and distributing of funds efficiently as compared to the commercial banks. In the end of this paper we tried to focus on signal of high acceptance of the interest-free banking by the public in general. The Islamic banking industry continued to show strong growth in 2005 in tandem with the growth in the economy, as reflected in the increased market share of the Islamic banking industry in terms of assets, financing, and deposits of the total banking system. The Islamic banks in Bangladesh started from a very limited resource base. But with the passage of time, they have shown strong performance in respect of mobilization of deposits.

TABLE OF CONTENTS

No

Contents Introduction

Page 4

1. 2. 3. 4.

Literature Review

Methodology Used in This Study

Theoretical Basis and Business Practice of Islamic Banking

5. 6. 7. 8. 9. 10.

The shock absorber (Mushakarah)

Sources of Funds of Islamic Banks

Performance Analysis of Islamic Banks

13

The Future of Islamic Banking in Bangladesh Conclusion and Implication

17 20

References

22

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ISLAMIC FINANCE SYSTEM WORKS AS A SHOCK ABSORBER BETWEEN DEPOSITOR & THE BORROWER, BY SHARING THE PROFIT & LOSS

INTRODUCTION:
The introduction of interest-free and equity-based financing by the Islamic banking system is based on the principles of Islamic economics. The aim of Islamic economics, as observed by Molla et.al. (1988), is not only the elimination of interest based tran sactions and the introduction of the Zakah (contribution to poor) system but also the establishment of just and balanced social order free from all kinds of exploitation. The Islamic banking system is highlighted in the World Development report (1989, Box 6.3), as under; Islamic banks offer savers risky open-ended mutual fund certificates instead of fixed-interest deposits. (This is not unlike cooperative banks and mutual in the west, where deposits earn variable interest and double as equity.) Difficulties arise on the lending side. Arrangements to share profits and losses lead to considerable problems of monitoring and control, especially in lending to small business. At birth, Bangladesh inherited an interest based banking system, which was introduced h ere earlier when the country was a part of British Colony. Since its inception Bangladesh saw a new trend in banking both at home and abroad. Islamic banking was successfully tries in Egypt. After the MitGhamar Model, Naser Social Bank was in the process of establishment. During the seventies, Islamic Development Bank (IDB) and a number of Islamic banks at national levels were established in the Islamic world. At home, the Islamic groups were vigorously working for adoption of Islam as the complete code of life. They found Islamic banking in ready form of immediate introduction. Two professional bodies Islamic Economics Research Bureau (IERB) and Bangladesh Islamic Bankers Association (BIBA) were taking practical steps for imparting training on Islamic Economics and banking to a group of bankers and arranging some national and international seminars/workshops to mobilize local and foreign people and attract investors to come forward to establish Islamic bank in Bangladesh. Their professional and right-thought activities were reinforces by a number of Muslim entrepreneurs working under the aegis of Muslim Businessman Society 9MBS). The body concentrated mainly in mobilizing equity capital for the emerging Islamic bank. Due to continuous and dedicated work of the above groups and individuals and active support from the Government, Islamic banking could be established in early eighties.
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LITERATURE REVIEW:
Ahmed (1994) argues that elimination of interest does not mean zero-return on capital. Rather, Islam forbids a fixed predetermined return for a certain factor of production i.e. one party having assured return and the whole risk of an entrepreneurship to be shared by others. The author also observed that it is the capital entrepreneurship that sh ares both the real contribution and the real profitability. The Islamic bank follows the principle of equity based investment. The Islamic banking system also proposes that resources can be contracted on the basis of venture capital and risk sharing deals. The idea of equity-based investment banking is not new to the financial market. If we look into history it may be observed that capital, as loan capital as well as venture capital played a great role in promoting industrial and economic development of various countries of the world. For example, during the 19th and 20th centuries investment banks played a great role in French tradition while in British model of banking equity- based investment was limited. Similarly in Germany equity-based investment was being practiced by commercial banks during that period. Even the banking crisis in the western world during the great depression in the 30s or the 80s proposed two -tire banking i.e. hundred percent deposit banking and the equity-based investment banking. In the modern financial market an alternate arrangement for participation of capital and entrepreneurship started with the advent of Islamic Banking in the 70s. In a number of studies such as IMF, World Bank and IFC, the Islamic bank activities were discussed in detail. Highlighting Islamic banks principle Khan (1986, p. 19), in the IMF staff Paper, observed as; Indeed it is really apparent that the Islamic model of banking based on the principle of equity participation bears a striking resemblance to proposals made in the literature on the reform of banking system in many countries. The Islamic System may well prove to be better suited to adjusting to shocks that result in banking crises and disruption on the payment mechanism of the country. In an equity-based system that exclude predetermined interest rate and does not guarantee the nominal value of deposits, shock to asset position are immediately absorbed by changes in the values of the share deposits held by the public in the banks. Therefore, the r eal value of assets and liabilities of banks in such a system will be equal at all points in time. In the more traditional banking system since the nominal value of deposits is fixed, such shocks can cause a diversion between real assets and liabilities. It is not clear if this would be correct and how long the process would take. A study by OECD of the European countries, Paris, (1983) reveals the fact that interest -free banking is a novel form of finance and they are not only trying to give interest anot her name but that legal instruments within the framework of Shariah exist which permit profitability on a different, albeit Quranically acceptable basis. Islamic banks belong to the class of equity participation bank. In this regard Ahmad (1994, P. 190) in his study quoted the idea of Albach as; They supply equity in the form of venture capital to investors whose share is their ingenuity

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and their labor. Secondly, they supply equity in the form of equity capital participants in the type of project, which in general has majority shareholders. They may be ideally suited to meet the need for equity capital in developing countries where the business risk is particularly high as well as in the industrialized countries where the development of new processes and new projects involves high risk and requires large amount of venture capital Scharf (1983, P. 94-95), in his study entitled Arab and Islamic Bank conducted by Development center, Organization of Economic Cooperation and Development (OECD), highlighted the Islamic banking principles and prospect as follows; Islamic banking is trying to develop the relationship between finance on one hand and industry and commerce on the other. This new relationship is the basis of the Islamic economic system being set up. Though Islamic principles have yet to be put to the test in the competitive of international finance, the two systems are similar in that they both strive for closer ties between financial intermediation and economic asset creation. Islamic banks could make a useful contribution to economic growth and development particularly in a situation of recession, stagflation and low-growth level because the core of their operation is oriented towards productive investment All countries both in the North and in the South, need more venture capital. Loan capital is available, particularly from industrialized countries but at high interest rates. However, even from expansion and innovation, this has acted as a brake on productivity and economic growth in the North. Thus practical and immediate cooperation possibility exists be- tween Islamic banks and enterprises all over the world. The intermediation process remains to be fully developed. About the possibility of introducing an interest-free financing system through Islamic banking principle Scharf (1983) also argues that the establishment Islamic Financial System based on the principle of Shariah is not only feasible but also profitable. Western countries today realize the truth that interest is an unbearable burden for the developing countries. Due to that, as observed by Ahmad (1994, p. 188), Canada has already waived of all the interest. Australia has made a similar move. President Mitte rrand of France has officially suggested in the Group-7 meeting that at least 30-35 percent of the present interest element of the debt should be waived off.

METHODOLOGY USED IN THIS STUDY:

Islamic banking systems are a quiet new phenomenon in the money market of Bangladesh. In order to go deep into this particular area of study and also to realize the objectives of our research, the methodological approach used in this study is of a qualitative nature. Regarding a qualitative research Merriam (1998, p. 5) observes; Qualitative research is an umbrella

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concept covering several forms of inquiry that help us understand and explain the meaning of social phenomena with as little disruption of the natural setting as possible. Further to the above, the author with regards to a qualitative research observes that this method is often used for interchangeably naturalistic inquiry, interpretative research, field study, participant observation, inductive research, case study and ethnography. To understand problems o f the Islamic banking activities a case study method is used in the study about which Yin (1994, p.13) argues that a case is an empirical inquiry that investigate a contemporary phenomenon within its real-life content, especially when boundaries between phenomenon and content are not clearly evident. The main objective of using case study method is to find how Islamic banks functions among other established conventional banks in the country. Hence, to realize they said objectives, apart from depth interview, participants observation is also used in the study.

THEORETICAL BASIS AND BUSINESS PRACTICE OF ISLAMIC BANKING:

From the viewpoint of Islamic Shariah, in order to be justified islamically the banking system has to avoid interest. Consequently, financial intermediation in Islamic banking between the bank and the client takes place as a partner rather than a debtor-creditor. The financial activities of modern conventional banks are based on a creditor-debtor relationship between depositors and bank on the one hand and between the borrower and the bank on the other. Conventional banks regard interest as the price of credit reflecting the opportunity cost of money. As interest is prohibited in Islam, commercial banking in an Islamic framework could not be based on the creditor- debtor relationship. The other aspect of the theoretical basis of Islamic banking is that the interest free bank is not risk free. This principle is applicable to two main factors of production, i.e. labor and capital. According to this principle, as no payment is allowed to labor, unless it is applied to work, no reward for capital should be allowed, unless it is exposed to business risk. From these two principles of the theoretical basis of Islamic banking, it may be said that Islamic financial relationships are of a participatory nature (Ahmad, 1993). Based on the theoretical background, business practices of Islamic bank, especially sources and uses of banks funds, are characterized by the following modes or techniques.

THE SHOCK ABSORBER ( MUSHARAKAH):

"Musharakah literally means sharing. In the scenes of business, sharing the profit and loss of an venture. But this concept of sharing (Musharakah) has deep implications in the modern context of the Islamic banking and finance system, which proved as an excellent alternative for the modern capitalist interest-based economy. In modern interest based economy, "Interest" is used as sole

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instrument indiscriminately in all kind of financing. As a result 'Musharakah" (Islamic Principle) can play a significant role for an economy. Interest is a fixed rate of return on a loan or a deposit, advanced by the financier irrespective profit or loss is consumed by the debtor. But Musharakah does not exercise on fixed interest rate. But they share the profit earned or loss incurred by the joint venture. The financier does not suffer loss, where in Musharakah both the financier and debtor suffer the loss if the venture fails to profit. If the debtor suffers a loss, it is unjust on part of the creditor to claim a fixed rate of return. On the other hand the debtor earns a very high rate of profit, which is injustice to the creditor to give a small percent of the profit leaving the higher for the debtor.

The basic rules of Musharakah: Since Musharakah is, in essence, a contract, according to Islam all conditions and rules of a contract must be followed. Apart from those, here are some basic rules specifically used for Musharakah.

Distribution of Profits: The proportion of profit to be distributed among the partners must be determined and agreed upon at the time of the contract. Otherwise the contract is not valid under Shariah. According to Imam Ahmed, the ratio of profit distribution may vary, without restriction, from the ratio of investment. According to Imam Malik and Imam Shafei, it is necessary that each partners share in the profit is exactly equal to the proportion of initial investment into the partnership. According to Imam Abu Hanifah, the ratio of profit distribution may vary, however, for silent partners (non-active partners, who only contribute capital), it cannot be any higher than the ratio of investment.

Distribution of Loss: All the Muslim jurists are unanimous that each partners share in loss must be exactly equal to the ratio of initial investment. Anything to the contrary will render the contract invalid.

The Nature of Capital: There are the following opinions on this: According to Imam Abu Hanifah and Imam Ahmed, no in-kind contributions are allowed in a Musharakah arrangement. This is because they believe it poses problems if the partnership needs to be liquidated or redistributed.

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According to Imam Malik and some Hanbali jurists, the nature of capital is not a restriction in a Musharakah arrangement. Therefore, in-kind (non-cash) contributions by partners are allowed. The share in partnership will be determined based on the market value of the commodity contributed. Imam Shafei makes a distinction between replaceable commodities and irreplaceable commodities (like cattle). The view is rather complex and not important for our purposes.

SOURCES OF FUNDS OF ISLAMIC BANKS:

Current Accounts: Islamic banks accept deposits from customers on current accounts as conventional banks do. This account is also known as Demand Deposit as the deposited amount is payable to customers on demand without any notice. As banks use current account de posits on their own risk the depositors of this type of account are not entitled to any share in the profit earned by the bank. Savings Accounts: Islamic banks accept saving deposits from customers under Al-Wadia and Al-Mudaraba Sharia Principles. The word Al-Wadia means Trusteeship. In this case banks act as trustee for its customers. In Saving Accounts under the Al-Wadia principle the bank is given an authorization by depositors to use the fund at the banks own risk. This type of deposit is almost similar to a Current Account or Demand Deposit except that the bank guarantees its customer the full return of the deposited fund with any profit voluntarily. Under the Al-Mudaraba Shariah principle there are two different types of savings accounts, such as - Savings under profit and loss sharing agreement and -savings under Investment Account. The word Al-Mudaraba originates from the word Mudarib and means The Manager of the fund. The bank in this case acts as a manager of customers funds. The depositors on the other hand are known as Sahib-Al-Mal meaning the owner of the fund. Deposits accepted on savings under the Profit and Loss sharing agreement is invested by the bank on its own risk. Customers give authorization to the bank to invest funds and share profit or loss on agreed proportions. Account holders of this type of account are required to maintain a minimum balance in the account.
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Further to the above, Islamic banks accept deposits from customers under the Investment Account on a Profit and Loss Sharing basis. The saving account of such a nature in an interest -

free banking system is also known as a participatory account or a Profit or Loss Sharing (PLS) account. Depositors of this type of account receive share of profit to the agreed ratio from their funds invested by the bank. The profit and loss sharing also depends on the total amount deposited and the length of period the bank holds the money. Depositors of an Investment Account are required to give prior notice to the bank if they withdraw their invested funds under any special circumstance. In such a case no share of profit is given for the amount withdrawn. Investment accounts are again subdivided into the following various categories. Joint or General Investment Account Limited-PeriodInvestmentDeposit Unlimited-PeriodInvestmentDeposit Specified Investment Deposit

Under the Joint or General Investment Account the bank pools together investmen t deposits of different maturities which are not invested in any specified project but utilized for different financing operations of the bank. Depositors of this type of account receive profits at the end of the period, which is accounted and distributed on a pro rata basis. The Investment Deposits on Limited Period basis indicates a type of investment, where the bank accepts deposits from customers for a specified period of time. The bank refunds the money to depositors after the time is expired. The profit generated from such funds is distributed at the end of t he financial year. The bank also accepts deposits from its customers under an Unlimited -Period Investment Deposit, where investment deposits are automatically renewable without specifying the period. Depositors of this type of account may withdraw their funds within three months notice to the bank. Profits are distributed to depositors at the end of the financial year. Some Islamic banks accept and Specified Investment Deposit, where the bank and the customer agrees to invest this fund to a specific project or trade. Profits accrued from this type of investment are shared by the bank and the customer. The bank in this regard, works as an agent for the customer, and may charge an agreed fee for the investment function or may share the profit at an agreed proportion.

Saving Deposit as Quard E Hasan: Apart from the above Islamic banks accept savings from customers as Quard E Hasan (benevolent loan) from the customers. Depositors of this sort of savings deposits receive financial or non-financial benefits from the bank.

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Uses of Funds of Islamic Banks: Based on the theoretical viewpoint as discussed earlier two fundamental techniqu es or modes of investment advocated by the Islamic Shariah Principle are; - Mudaraba (Capital Financing) - Musharaka (Partnership)

Mudaraba (Capital Financing): Capital Trust financing is a contract between at least two parties in which the bank as the investor supplies the entire capital of the business forming a relationship between the supplier of capital and the user of capital. These two parties work together and share profits and losses. Under Murabaha financing the investor is known as Rab-Al-Mal, which means the owner of the property, and the entrepreneur is called Mudarab, meaning the manager of capital. When the venture ends, the manager of capital i.e. the entrepreneur returns the entire capital to the bank, along with an agreed proportion of profit. If there is any loss, it is born by the bank. The main advantage with this type of partnership is that it combines the efforts of human beings and their skills with the capital, which contribute greatly towards the development activities in a society and also assists to solve unemployment problems by utilizing manpower resources in a productive way.

Musharaka (Partnership): The word Musharaka means a profit sharing joint venture, designed to limited production or commercial activities of long duration. In this case the bank and the customer contribute capital jointly. They also contribute managerial expertise and other essential services at agreed proportions. Profit or losses are shared according to the contract agreed upon. An individual partner does not become liable for the losses caused by others. In addition to the above two financial arrangements, Islamic Banks currently in existence are also engaging in or actively considering several other financial practices usually acceptable in Islamic Law. These are: Murabaha (Mark-up or Cost-Plus-based Financing) Ijara (Leasing) and

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Quard- E- Hasan (Interest-Free Loan)

 Murabaha (Cost plus profit): The word Murabaha means a cost-plus Profit contract. In this system of financing the bank agrees to purchase for a client who will then reimburse the bank in a stated time period at an agreed upon profit margin. The mark-up price that the bank and the buyer agree to is mainly based on the market price of the commodity. Thus the bank earns a profit without bearing any risk. Ijara (Leasing): The word Ijara indicates leasing. The leasing purchase is another technique follo wed by Islamic banks in financing customers. This system is almost similar to the leasing activity provided in traditional banking. Leasing is a contract between the bank and the customer to use particular assets. In this case the bank is called lessor and the customer is called lessee who wants to use the assets and pays rent. Zineldin (1990, p.83), in this regard argues as, The leasing agreement is based on profit sharing in which the bank buys the movable or immovable property and lease it to one of its client for an agreed sum by installments and for a limited period of time into a saving account held with the same bank. These installments are invested in Mudaraba investment (Venture) for the customers account. The accumulated profit generated from the payments, and the payments themselves are invested in the banks investment ventures over the time period of lease, contributing to eventual purchase of the leased assets. According to the Western leasing system the lessee pays specific rentals and a fixed rate of interest over a given period for the use of specific assets. But in the Islamic banking system of leasing the risk related to leasing has to be shared between the bank and the lessee, in case of any damage to the leased assets. The contract is called ijara -wa-iqtina i.e. leasing purchase, when the ownership of the assets is transferred to the clients after the completion of the leasing contract.

Quard E Hasan (Interest free loan): Quard E Hasan means an interest-free loan given by the Islamic bank to the needy people in a society. The practice of dealing with this sort of investment differs from bank to bank. Quard E Hasan is normally given to needy students, small producers, farmers, entrepreneurs and economically weaker sections of the society, who are not in a position to obtain loan or any financial assistance from any other institutional sources. The main aim of this loan is to help needy people in a society in order to, make them self-sufficient and to raise their income and standards of living. (Zineldin, 1990; Khan, 1897; Kazarian, 1991, Ahmad, 1993)

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PERFORMANCE ANALYSIS OF ISLAMIC BANKS:

Performance evaluation is an important pre-requisite for sustained growth and development of any situation. It is customary in commercial banks to evaluate the pre -determined goals and objectives, with the changes goals and objectives, the criteria of revaluation has undergone changes overtime. Regarding performance evaluation of the Islamic banking in Bangladesh Banking Efficiency Model has been taken into consideration. Banking Efficiency Model: Banking Efficiency Model Criteria (five efficiency test criteria) has been developed to measure the efficiency of the Islamic banking system. These criteria are measures and expressed in terms of ratios. Performance Analysis of the Islamic Banks: As discussed earlier now we are analyzing performance of the Islamic banks by following the Banking Efficiency Model Criteria i.e. five efficiency test criteria to measure the efficiency of the Islamic Banking System of Bangladesh. The discussion deals with the empirical testing of the findings from dynamic analysis to see what is the overall efficiency and performance level of Islamic banks operating within a conventional banking set-up in Bangladesh. Primary Data has been collected from the banks concerned departments.

Productive Efficiency of the Islamic Banks: Of the five efficiency test criteria enlisted under Productive Efficiency, Investment, Opportunity Utilization Test is one, which is described first.

A. Investment Opportunity Utilization Test: Under production efficiency, we find that fund Utilization Rate (FUR) of IBBL went up progressively from 1989 to 199; by it falls at 0.75 in 1993 while it was more than 100% in 1996, but again falls to 0.88 in 1997. This is shown at Annexure - I. This rate for Al-Baraka depicts a higher trend after the year 1989 because a huge amount of non-performing assets. Normally this rate will be much below of the present rate. AIBL recorded at 65% for 1996 and 75% for 997. This also depicts an increasing trend in fund utilization. SIBL also recorded this rate at 65%-63% level Islamic banking branches of PBL also utilized their fund by 48.70% in 1996 which falls at 30.23% in 1997, because of their one new branch opened this period. HIBB also depicted a lower rate at 21% only due to investment in limited area. Per employee deposit mobilization shows the mixed trend for IBBL, but it came to double in 1997 from 1988. ABBL another Islamic bank also shows an increasing trend. Per employee fund

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utilization also shows the same trend for all banks. Though relatively better but still below the optimum level of fund utilization by the Islamic banks was due to competition among them and hard situation of the economy. Th e second important reason as considered being the most important is the borrowers behavior in making choice between the conventional and Islamic banks.

B. Profit Maximization Test: All the four indicators o Profitability (viz., Income - Expenditure Ratio, Profit-Expenditure Ratio Profit - loanable fund Ratio and |profit Employed fund Ratio) indicate the IBBL and Al-Arafah experienced declining trend while ABBL and SIBL incurred huge amount of losses for may years.The declining trend of the above two Islamic banks were due to growing percentages to their investments which were converted into bad debts provisions for classified loans. Amon g other two banks, ABBL has been incurring losses due to huge amount of non -performing loans while SIBL was making loss during that period due to conflict between owners and Management of the Bank.

C. Project Efficacy Test: How far a bank can contribute effectively, in running a projected by it, can be primary determined by the level of linkage in can establish through its financing mechanism. These are: Project selection criteria; Pre-financing appraisal of projects; Post-financing supervision; Built-in mechanical linkage of the bank to its financed projects.

Analysis based on the discussion with the Executives of the banks reveals that Islamic banks take utmost attempt for selecting efficient projects but they cannot supervise post-financing situation in most of the cases. Thats why, a borrower diverted elsewhere and project could be sick and affect recovery of loans. The mark-up based mechanisms presently followed by the Islamic banks are essentially not much different from conventional banks in ensuring effectiveness of projects financed by them. It is because of the fact that an Islamic bank practices mostly the trade related modes that have little or no relevance to project financing.

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It is depicted from an analysis in the central bank that the amount of bad debts of the Islamic banks is growing. The ratio of bad debts to total debts stood at 20% in 1997 from the level of

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A. Loan Recovery Test:

18% in 1996. However, some new legal provisions are underway for enactment shortly to provide some avenues of overcome acute overdue loan position of the banks. B. Test of Elasticity in Loan Financing: Loan financing mechanism of Islamic banks is still less elastic. The Islamic banks in the country are facing the problems as they lack suitable modes in meeting call loan demands as well as working capital needs of the entrepreneurs. They also ace problems in inter-bank borrowing due to lack of suitable financing modes. i) Operational Efficiency of the Islamic Banks: Two criteria have been used to measure operational efficiency of the Islamic banks. These are: per Employee Administrative Cost (PEAC), and Administrative Cost - Loanable Fund Ratio (ACLFR). Annexures - II presents this situation. It is seen from the above table that PEAC of all Islamic banks are increasing. PEAC for IBBL in 1998 Taka 91362.00 which reached at Taka 188,807 in 1997. ACLER of the Islamic banks is also denotes an increasing tre nd. Though these ratios are increasing, they are stably increasing. So operationally the Islamic banks are good and stable. ii) Allocative Efficiency of the Islamic Banks:

The first component in measuring allocative efficiency is the application of modes of financing. The mode-wise investment situation of the Islamic banks depicts that Annexure - III) shortterm trade financing on the basis of mark-up have been extensively used. On the other hand, Musharaka and Mudaraba, the two distinguishing modes where profitability acts exclusively as allocative device, have their declining share in the portfolio distributions of the Islamic banks. Annexure - III of all Islamic banks shows that the investment under Musharaka has declined where there has been a single investment under Mudaraba. So, in allocation of the financial resources the Islamic banks in Bangladesh could never Mudaraba. So in allocation of the financial resources, the Islamic banks inBangladesh could never use Mudaraba financing as a tool for investment. The reason for not using the PLS by the Islamic banks :

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Under-reporting of profit by the entrepreneurs to evade taxes widely matters to the application of PLS modes since both Mudaraba and Musharaka re profit sharing contracts between the bank and the entrepreneurs, maintenance of proper accounting and declaration of actual profit by the entrepreneurs are extremely essential for the bank. Under reporting of profit in one of the server moral hazards in Bangladesh. This has been established as rule rather than an exception. As a result, entrepreneurs, Interest in Riba free banking prefers making their transactions through modes other than Musharaka and Mudaraba. Islamic banks, for the same reason, appear to be comparatively less important in Bangladesh.

The change in the pattern of financing by the Islamic banks reflects disappointing result in the application of Musharaka mode - a distinguishing feature of Islamic banking. Mudaraba, another mode of financing under PLS could not yet have been attempted by the Islamic banks due to wide apprehension of risks in regard to safe return of capital and profit. However, it is seen from the Annexure - IV that investment in Musharaka financing came down from 3.18% in 1996 to 2.61% in 1997 of IBBL and 2.11% in 1996 to 0.86% in 1997 for SIBL respectively while all other Islamic banks excepting Al-Arafah (investment of Al-Arafah under Musharaka mode stood at Taka 2.51 million or 0.14% of her total investment in 1997) did not make any investment under this operation of Islamic banks in Bangladesh that Utilizations of PLS modes of finance like Musharaka is declining and no investment of the other PLS mode - Mudaraba.

i) Distributive Efficiency of the Islamic Banks: Three criteria have been applied to measure distributive efficiency. The first deals with for percentage shares of banks gross income going to the banks and the depositors. Profits income Ratio for the Islamic banks serves as an indicator of the first criterion. The second criterion analyses distribution of deposits and advances to trade out the bias to them. Profit-income Ratio denotes percentage share of Islamic banks income distributed to the depositors as profit. It is assumed that a high value of the ratio indicates a te ndency towards better distribution of incomes generated through the financing process. In case of IBBL, this ratio came down from 23.01% in 1996 to 12.47% in 1997 while this ratio for Al-Arafah went up from 9.16% in 1996 to 31.10% in 1997 respectively. The same for Al-Baraka and social Investment Bank denotes negative sign because Al- Baraka has been maintaining provision for huge bad debts loss since 1990. On the other hand, SIBL was in turmoil for conflicting situation prevailed in the bank between the Chairman and the management for the bank for a long period till mid - 1998. But, now the overall situation of Al-Baraka and Social Investment Bank has been changing toward better loan discipline and establishment o cooperative atmosphere be- tween the owner and manager. It is reported in the half-yearly Balance-sheet of Al-Baraka for the period June 1998 that the bank has been able to make profit. SIBL is also marching to reduce their losses. However, it should be noted that, loss of al-Baraka has been reduced to Taka 162.12 million in 1997 from Taka 273.20 million in 1996 and the same has also been reduced in case of SIBL to Taka 5.46 million in 1997 from Taka 1894 million in 1996. As far as the growth of Deposits of the Islamic Banks in Bangladesh is concern ed, the yearly rate of growth of deposits for IBBL was on average 20%. For other Islamic banks this average growth rate were: 10% for ABBL, 300% for Al-Arafah (for strong drive) 140% for SIBL. The two Islamic banking branches of Prime Bank Limited also made remarkable progress in mobilization of deposits. These two branches had mobilized by 2483.45% or Taka 400.83 million of Taka 416.97 million in 1996 while this growth had slightly fell by Taka 12.74 million in 1997. The analysis of deposit accounts by size reveals that deposits accounts belongs to account

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category of Taka 10,000.00 and below represented by 5.84% for IBBL while investment is made to same size of accounts by 0.67|% only. This percentage were: 9.04% for ABBL (investment was 0.001%), 0.03% for AIBL (investment 0.0001%), 0.01% of SIBL (investment 0.01%) while at the deposit range up to Taka50,000.00, the ratio were: 0.06% for IBBL (investment was 0.01% for SIBL (investment 0.15%). Again if we take an account of 50% of total deposits of the Islam ic banks, we find that 50% of the deposits came from the account size up to Taka 300,000.00 and investment was made to them only by 0.03%. That is, Islamic banks in Bangladesh are not exceptional to the current trend of transferring investible resources from the low-income depositors to high-income borrowers. This of banking equally created more income inequality. Rural-Urban classification of deposits and advances of bank shows its allocation pattern of financial resources have distributional implications. Due to non-availability of data within this time period, it was not possible to analyze this aspect. However, according to Quarterly Scheduled Banks Statistics, the total distribution of deposits of the banking system by urban rural areas revealed that this ratio was 77.23 during April-June 1997 while this Ratio for advances was 82:18 for the same period. Though the report explains the overall position of the banking system, if we deduct the operation of government -owned banks, than the ratio will be very must lower an urban bias of investment will be prominent in the private sector banks, as well as of Islamic banks because their investment operation was basically designed as urban oriented

ii)

Stabilization Efficiency of the Islamic Banks.

The moral integrity of the entrepreneurs of Bangladesh may be assumed to observe the huge amount of bad debts that have cause serious problem for clean Islamic banking. Moreover, political intervention in selection of borrowers, shock of financial instability, inability of the government of restore law and order in the country, especially framing low regarding the recovery of bad debts etc. have major influence causing to poor implementation in investment projects. In case of Islamic banks, it may be concluded that full dependence o n Mark-up based financing would not lead to attain stabilization efficiency; PLS modes of financing may attain this efficiency through collateral-free participatory-based banking.

THE FUTURE OF ISLAMIC BANKING IN BANGLADESH:

1. Need for Re-organization of the whole financial System Review of the problems of Islamic banking in general and Islamic banks of Bangladesh in particular poses a challenging feature for the promotion and survival of Islamic banks in Bangladesh. The policy implication is not that Islamic banks should never be floated within the conventional banking framework. Rather it is the conventional banking system whose

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operational mechanism needs to be re-examined and converted into PLS system considering beneficial impact of the latter on the economy. However, as long as Islamic banks are to operate within the conventional banking framework, the recommendations under the following heads may be taken note of. 2. New banking philosophy for the Islamic Banks There seems to be a gap between the ideals and actual practice of Islamic banks in Bangladesh. In their reports, booklets, bulletins and posters there banks express their commitment to striving for establishing a just society free from exploitation. Study shows that a little progress has been achieved so far in that direction. Though this failure is attributed mainly to the pervasive influence of conventional banking system itself, lack of vigilance of the promoters of Islamic banking in realizing the objective is no less to blame. There should be a thorough review of policies that have been pursued by these banks for about a decade and points of departure have to be identified to redesign their of action. 3. Future Policy and Strategy The first action that deserves immediate attention is the promotion of the image of Islamic banks as PLS banks. Strategies have to be carefully devised so that the image of Islamic character and solvency as a bank is simultaneously promoted. To this end, Pilot schemes in some very selected areas should be started to test innovative ideas with profit-loss-sharing modes of financing as major component. Islamic banks should clearly demonstrate by their actions that their banking practices are guided by profitability criterion thereby establ ishing that only Islamic banking practices ensures efficient allocation of resources and provide true market signals through PLS modes. Islamic banks should continuously monitor and disseminate through various means the impact of their operations on the distribution of income primarily between the bank and the other two parties: the depositors and the entrepreneurs, and then on different income groups of the society. These presuppose establishment of a fully equipped research academy in each Islamic bank.

4. Stepping for Distributional Efficiency. The task is more challenging for Islamic banks, as they have to promote their distributional efficiency from all dimensions together with profitability, Islamic banks, step by step, have to be converted into profit-loss-sharing banks by increasing their percentage share of investment financing though PLS modes. The Islamic banks, to do that, can be selective in choosing clients for financing under PLS modes. They should establish direct functional relationship betw een the income of the depositors and between the income the income of the bank and that of the entrepreneurs. The relationship improves with share of bank financing under PLS modes increases.

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5. Promotion of Allocative Efficiency The Islamic banks can improve their allocative efficiency be satisfying social welfare conditions in the following manner. First, they should allocate a reasonable portion of their investible funds in social priority sectors such as agriculture (including poultry and fishery), smal l and cottage industries and export-led industries like garment, shrimp cultivation. Secondly, when the percentage shares of allocation of investible funds are determined among the sectors of investment financing, profitability of projects should be the criterion for allocating investment funds. The criterion would be best satisfied if more and more projects were financed under PLS modes. 6. Modern banking Policies and practices Islamic banks, with a view to facing the growing competition either fellow-Islamic banks or the conventional banks which have launched Islamic banking practices, will have to adapts their functioning in line with modern business practices, though improvement and expansion of the range of dealing in the banking sector. Thus, it is necessary for them to provide comprehensive banking and investment services to clients and simultaneously to take advantage of modern technological breakthroughs in areas such as electronic communication, computerization etc. 7. Government and Central bank Responsibilities Government should think actively for the promotion of Islamic banking in Bangladesh considering its pro-development role. It should amend existing financial laws, acts and regulations to create favorable environment conducive to smooth operation of Islamic banks. The bank Reforms Committee may be entrusted to draft an Islamic Banking Act. Government should also allow establishment of Islamic insurance and other subsidiary companies in order to facilitate their operation. Bangladesh Bank should develop some Islamic Monetary and saving instruments and create separate window for transactions with the Islamic banks and a full-fledged Islamic banking Department for analyzing, supervising, monitoring and guiding purpose, thereby facilitating Islamic banks for their smooth development in Bangladesh.

8. Inter-Islamic Bank Co-operation and Perspective Plan All Islamic banks should come forward to help each others and adopt a perspective plan say for 20 years for Islamization of the banking system of Bangladesh. To actualize this mission, they should set-up immediately and Apex Research Academy and Training Institute designed with modern tools.

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CONCLUSION AND IMPLICATION:

1. Islamic banks can provide efficient banking services to the nation if they are supported with appropriate banking laws, and regulations. This will help them introducing PLS modes of operations, which are very much conducive to economic development. It would be better if Islamic banks had the opportunity to work as a sole system in an economy. That would provide Islamic banking system to fully utilize its potentials. Studies show that Islamic banks cannot operate with its full efficiency level if it operates under a conventional banking framework, their efficiency goes down in a number of dimensions. The deterioration is not because of Islamic banks own mechanical deficiencies. Rather it is the efficiency-blunt operations of the conventional banking system that puts obstructions to efficient operation of Islamic bank s. This does not mean that the survival of Islamic banks operating within the conventional banking framework is altogether threatens. Evidences from Bangladesh indicate that Islamic banks can survive even within a conventional banking framework by which over from PLS to trade related modes of financing. 2. Even under the conventional banking framework Islamic banks can operate with certain level of efficiency by applying in a reasonable percentage the PLS modes. The distinguishing features of Islamic banking. This has been possible in some countries of the Muslim world where the management of Islamic banks was cautious about possible impacts of every policy measure. Particularly, the management of these banks was judicious in selecting sectors or areas as major of their operations. Sudan Islamic banks are a typical example in this respect. Islamic banks in Bangladesh have much to learn from the experience of this successful Islamic bank. 3. Having been considered the pro-efficiency character of Islamic banking and its beneficial impacts on the economy, government policy in Bangladesh should be in favor of transforming conventional banking system into Islamic banking. It is reasonable to assume that risks involved in Mushraka or Mudaraba financing are different from those involved in trade-type financing. It follows, therefore, that prudential regulations of these transactions should be different. 4. Determination of profit and loss in profit/loss sharing arrangement and treatment of costs and reserves in such accounting is a pertinent issue to be addressed with utmost importance and priority. However, Islamic banking is a very critical institution to materialize the economic objectives of Islam. It should however, be noted that it is of the whole of the Islamic framework. Compared to the conventional banks it is very much viable by itself, but the full impact of it can only be realized by supplementing it with corresponding reforms in other spheres of life in general, and in the monetary and fiscal fields in particular. Finally, it may be mentioned that if the Islamic financial system, is to become truly liquid and efficient it must develop more standardized and universally (or at least widely) tradable financial instruments. The development of a secondary financial market for Islamic financial products is crucial if the industry is to achieve true comparison with the conventional system. It must also work hard to

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develop more transparency in financial reporting and accounting and ideally - a form of Islamic GAAP. Development if the whole sale and especially inter-bank and money markets, will be the key to Islamic finance growing outside its current little sphere of influence, and becoming a truly national invigorating force.

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Al-Bakara Bank Bangladesh Limited 91987): Memorandum and Articles of Association of al-Baraka Bank Bangladesh Limited. Al-Arafah Islamic Bank Limited (1995): Memorandum and Articles of Association of al Arafah Islamic Bank Limited. Social Investment Bank Limited (1995): Memorandum and Article of Association of Social Investment bank Limited. Prime Bank Limited (1997): Annual Report, 1997, Page 15. Islamic bank Bangladesh Limited: Tiaras Councils Reports, 1984-1997. Research Department, Bangladesh Bank (1997): On the Dynamism of Islamic banking in Bangladesh, latter issued to all the Islamic banks and Banks having Islamic banking Branches and Counters on 15th March, 1997 (Letter No. DR/PIED/IEC) 1/97). Islamic Banks Consultative forum (IBCF) 1997: Minutes of the first Meetings of all Islamic Banks and Banks having Islamic Board rook of Islamic Bank Bangladesh Limited, Dhaka, Bangladesh. Bangladesh Bank: Minutes of the Discussion Meeting held at Bangladesh \bank with the Chairman and Managing Directors of the Islamic Banks on September 14, 1998. Khan, M.A. (1989): A Survey of Critical |Literature on Interest-Free Banking Journal of Islamic Banking and Finance 96:1), Karachi, Pakistan. Mirakhor, A: Progress and Challenges of Islamic banking, Review of Islamic Economics, vol. 4, No.2, 1997. Ahmed, E.A: Islamic banking: distribution of Profit (Case Study), unpublished Ph.D. Thesis, December 1990, University of Hull, UK. Ismail, Gulam Sufyan, Islamic finance explained, http://www.nzibo.com/IB2/IFExplained.pdf

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