Islamic Banking in Bangladesh: Current Status, Challenges and Policy Options

Md. Golzare Nabi1

Dr. Md. Aminul Islama

Dr. Rosni Bakarb

Asma Akterc

Abstract

In tandem with the global rapid expansion of Islamic banking, Bangladesh has experienced

phenomenal growth in Islamic banking following strong public demand for the system. Since

its inception in 1983, Islamic banking industry has recorded robust performance and the

industry now accounted for more than twenty percent market share of the entire banking

industry in Bangladesh. Though Islamic banking industry in Bangladesh has achieved more

than 20 percent annual growth, the industry has immense potentials for further expansion as

Bangladesh is a Muslim majority country with a vibrant economy of 6 percent real economic

growth over the last decade. To reap the full potentials of Islamic banking, it is imperative to

assess the present status of Islamic banking industry in Bangladesh. Given this, the present

paper investigated the present status of Islamic banking industry and it also assessed its

comparative performance with overall banking industry. To attain the objectives of the paper,

required information/data have been collected from the secondary sources and financial ratio

analysis approach has been applied. Finally, the paper shed light on challenges faced by the

Islamic banking industry and prescribed policy options to meet the challenges.

JEL Classification: G10, G21, G28

Keywords: Islamic banking, challenges, policy options

1. Introduction

With a timid beginning in 1960s, the Islamic financial industry has now gained popularity in

both Muslim and non-Muslim countries attracting customers of all faith due to its resilience

and less risky character. In tandem with the global rapid expansion of Islamic banking,

1 PhD Candidate (Finance), Universiti Malaysia Perlis (UniMAP), Malaysia and Corresponding author. He is also Deputy General Manager, Research Department, Bangladesh Bank, Central Bank of Bangladesh, Dhaka, Bangladesh. Corresponding author’s e-mail: golzare@gmail.coma Associate Professor and b Professor, School of Business Innovation and Technopreneurship, Universiti Malaysia Perlis(UniMAP), Malaysia. c Assistant Director, Research Department, Bangladesh Bank._ Views expressed in the article are authors’ own and do not reflect the views of the institutes in which they work.

1

Bangladesh has experienced phenomenal growth in Islamic banking following strong public

demand for the system. Since inception in 1983 Islamic banks have recorded robust

performance; at present they accounted for more than twenty percent market share of the

entire banking industry in Bangladesh. Though Islamic banking industry in Bangladesh has

achieved more than 20 percent annual growth, the industry has immense potentials for further

expansion as Bangladesh is a Muslim majority country with a vibrant economy of 6 percent

real economic growth over the last decade. To reap the full potentials of Islamic banking, it is

imperative to access the present status of Islamic banking industry in Bangladesh, review

further potentials and design proper policy options. Given this, the present paper investigated

the present status of Islamic banking industry and it also assessed its comparative

performance with overall banking industry. Finally, the paper shed light on challenges faced

by the Islamic banking industry and prescribed policy options to meet the challenges.

The objective of the present paper are two-fold: first, to review present status and challenges

of Islamic banking in Bangladesh and second, to put forward policy options to build a sound

Islamic finance architecture capable for meeting up the growing demand of Islamic financial

products. To attain the objectives of the paper, the required information/data have been

collected from secondary sources. The secondary sources included different reports of

Bangladesh Bank, Islamic Banks and other national and international Research

Organizations, and scholarly articles published in domestic and International Journal.

Financial ratios have been used to assess the status of Islamic banks and make comparison

with the conventional banks.

The remaining part of the paper has been organized into the following chapters. Chapter 2 is

devoted to review of literatures and chapter 3 focuses on global experiences in Islamic

finance. Chapter 4 analyses current status of Islamic banking in Bangladesh. A comparative

analysis of performance between Islamic banking and overall banking industry in Bangladesh

has been made in chapter 5. Chapter 6 shed lights on challenges of Islamic banking in

Bangladesh while chapter 7 provides policy options and conclusions.

2. Literature Review:

Though Islamic banking has made significant progress in Bangladesh during the last three

decade, there is dearth of quality studies/papers addressing key issues of Islamic banking in

Bangladesh. Most of the studies done in the context of Islamic banking in Bangladesh have

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so far focused on performance of banks and legal issues based either on few samples or

narrower perspective or short time span. As there is research gap in Bangladesh Islamic

banking, an in-depth and comprehensive research is required on current status of Islamic

banking in Bangladesh for proper dissemination of information among regulators, managers,

investors and general customers.

Hassan, M. Kabir (1999) explained the basic elements of interest- free banking in details and

its practical experience in a developing Muslim majority country, Bangladesh. The paper

analyzed the performance of ‘Islami Bank Bangladesh Limited (IBBL)’, the first Islami Bank

in Bangladesh based on growths in deposits, investment, profit, international trade,

remittances and expansion of branch net work during the period of 1983-94. The paper also

made comparison of IBBL’s performances with those of other private banks during the same

period. The key recommendations made in the paper included diversification of lending

portfolios into long term financing under Musharaka and Mudaraba, selection of customers

based on quality and genuineness of projects, imparting knowledge of Islamic banking

among customers and creation of interest free money market instruments by central bank.

Sarker, Md. A. A. (1999) evaluated performances of Islamic banks in Bangladesh during the

period of 1988-97. The paper used five efficiency test criteria (mainly financial ratios) to

measure the performance of Islamic banks. The paper reported that only Islamic Bank

Bangladesh Limited, the first Islamic Bank in Bangladesh maintained positive growth trend

in deposits, advances and profits during the period under report. Investments under

Musharaka, ideal partnership mode was below 3% of total investments and no investment

was made under Mudaraba, another ideal mode during the period under report.

Alam, M. N. (2000) attempted to analyze growth trends of deposits and investments of the

first and large Islami Bank in Bangladesh ‘Islami Bank Bangladesh Limited (IBBL)’ during

1983-94. The paper found that the IBBL mobilized deposits mainly under AL-Wadia and

Mudaraba modes. The paper revealed that the bank made investments mainly under

Murabaha, Musharaka, Bai-Muajjal, Hire Purchase, and Quard E Hasana mode of

investments. Among different mode of operations, the bank concentrates on the Murabaha,

Bai-Muajjal and other related mode of investments. Musharaka and Quard E Hasana modes

recorded below 3% of the total investment and no investment has been made under

Mudaraba.

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Ahmad, A. U. F., & Hassan, M. K. (2007) examined current legal and regulatory issues of

Islamic banking in Bangladesh. The paper pointed out that there is a lack of a well-defined

regulatory and supervisory framework for Islamic banks for their effective functioning in line

with the tenets of Shariah. The other major issues included absence of an interbank Islamic

money market, presence of a discriminatory legal reserve requirement for Islamic and

conventional banking, prevalence of a restrictive environment in the capital market, and the

lack of legal support and protection of Bangladesh Bank to avoid the associated risks of

Islamic banks. The paper suggested that Islamic banks in Bangladesh should have an

independent banking act that controls, guides, and supervises their functions and provide

legal support to the parties concerned.

Mamun, Dr. Muhammad Z (2008) shed light on the prospect and growth potentials of Islamic

banks in Bangladesh as perceived by Islamic and conventional bankers. The paper

investigated the factors that motivate banks to adopt Islamic banking methods, the reasons

which attract consumers towards Islamic banks and the factors responsible for hindering

growth of Islamic banks. The paper identified adherence to the rules of Shariah as the

foremost factor to customers in choosing Islamic banking services. The paper pointed out

opinions of conventional bankers that the preferential treatments that Islamic banks receive

from central bank contribute to their profitability and this factor plays a crucial role in

motivating some conventional banks to offer Islamic banking as a parallel service. The paper

found that lack of supportive legal framework works as the primary factor in hindering

growth of Islamic banking in Bangladesh.

Mahmud, Abdullah Al & Islam M. Muzahidul (2010) paper focuses on the comprehensive

comparison about the performance of conventional and Islamic banking system operation in

Bangladesh during 2000-2005. Some commonly used measures such as general business

measures, profitability ratios, management soundness and social profitability have been

applied to derive the objectives of the paper. The paper found that though both conventional

and Islamic banking have contributed a lot to the economy of Bangladesh, there are two

major functional differences. Firstly, the conventional banks follow borrowing and lending

mechanisms while the Islamic banks abide by trading and investment mechanisms. Secondly,

the conventional banks provide and receive interest for deposit and advance but Islamic

banks neither accepts nor pays interest in any of its activities and run business based on profit

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as a pricing tool instead of interest. The study reported better performance of Islamic banks as

compared to that of conventional banks.

Muhamad, Abduh et.al., (2013) attempted to investigate the efficiency and performance of

five major Islamic banks in Bangladesh. In the paper, ratio analysis and data envelopment

analysis methods have been applied to measure the performance and efficiency of Islamic

banks with data collected from published annual reports during the period of 2006-2010. The

paper found that the trend of all Islamic banks was on the rising stage during year 2006 to

year 2010, suggesting that the Islamic banks have improved their efficiency over the study

period. The paper also suggested further research applying stochastic frontier approach with

more variables, enhancing number of time period and making comparison between

conventional and Islamic banking.

Sadekin, Md. Nazmus et.al., (2014) analyzed the performance, development and growth of

selected five Islamic Banks in Bangladesh. Seven variables namely number of

branches, number of employees, total deposits, total investments, total remittance, net Income

and earnings per share during the time span of 2008 to 2012 has been used to derive results of

the paper. Eight trend equations have been tested for different activities of the Islamic banks.

They found that the trend value of branches, employees, deposits and net income are positive

in case of all the selected banks. The trend value of branches, employees, deposits and net

income is positive in case of all the selected banks. Square of correlation coefficient (r2) has

also been tested for all trend equations. They revealed that the r2 of branches, deposits and net

income is more than 0.5 implying that the future of the Islamic Banks in Bangladesh is very

bright.

Ibrahim, Md et.al., (2014) evaluated the performance of six Islamic banks listed at both

Dhaka Stock Exchange (DSE) & Chittagong Stock Exchange (CSE). Data have been

collected from the annual reports of the selected banks and variables chosen for performance

evaluation included deposit, investment, foreign remittance, earnings per share (EPS),

dividend declaration, dividend payout ratio, price earnings ratio (P/E) and net asset value

(NAV).Analyzing these variables, the study concluded that Islamic banks have performed

well.

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IFSB (2014) has attempted in a publication prepared on papers delivered at a seminar in

Dhaka, Capital of Bangladesh to share the prospects and challenges, initiatives and

experiences, in developing Islamic finance, with specific focus on the Bangladesh experience.

The publication published by IFSB has six chapters covering different key issues relating to

Islamic finance in Bangladesh and other countries.

3. Global Experience

Starting in Egypt in 1963, the Islamic finance industry has now come of age as a viable,

resilient and suitable alternative in the global financial landscape. The finance industry began

as a niche market mainly in retail banking and currently, it has been operating in 75 countries

with 600 institutions offering wide range of Shairah complaint financial products ranging

from commercial and investment banking to takaful (insurance), mutual funds and capital

market products. The Islamic finance is not only flourishing in Muslim majority countries

worldwide but it is also expanding fast in non-Muslim countries attracting both Muslim and

non-Muslim customers. During the global financial crisis of 2007-2008, the conventional

financial industry faced severe turmoil across the global but the Islamic finance industry

showed much resilience compared to their conventional counterparts. This has created much

enthusiasm among policy makers around the world that Islamic finance has solid ability to

maintain financial stability.

The Islamic finance industry has experienced unprecedented progress in terms of

geographical converge, offering diversified Islamic financial services and exponential

growth. The total assets of global Islamic finance industry are estimated to be worth USD

1.87 trillion in 1H2014 from USD 1.50 billion in mid-1990s. The global Islamic financial

industry comprising banking, sukuk, mutual funds, and takaful has witnessed robust growth

with a compound annual growth rate (CAGR) of 17% between 2009 and 2013. The status of

global Islamic financial industry is depicted in Table-3.1.

Table 3.1: Geographical Distribution of Islamic Finance Segments (2014) (USD billion)

Region Banking Assets Sukuk Outstanding Islamic Funds’ Assets Takaful ContributionsAsia 203.8 188.4 23.2 3.9GCC 564.2 95.5 33.5 9.0MENA (exc. GCC) 633.7 0.1 0.3 7.7Sub-Saharan Africa 20.1 1.3 1.8 0.6Others 54.4 9.4 17.0 0.3Total 1476.2 294.7 75.8 21.4Source: Islamic Financial Services Industry Stability Report 2015, IFSB, Malaysia.

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The Islamic banking sector has dominated the global Islamic financial industry with higher

concentration in the MENA, GCC and Asian regions as they have larger Muslim population

and vibrant emerging economies, mostly based on petro dollar.

The Islamic capital market, namely Sukūk, Islamic funds and indices continued to outpace

most other asset classes in the global financial system. Both government and corporate

sectors are increasingly using ‘sukuk’ as an important vehicle for international fund-raising

and investment activities that generate significant cross-border flows. At present, there are

four major global Islamic indices providers that cover the Islamic equity market- Dow Jones

Islamic Market Indices, Standard and Poor Shariah Indices, MSCI global Islamic Indices and

FTSE global Islamic Indices. Malaysia, Qatar, the UAE, Saudi Arabia and Indonesia have

been at the forefront of growth in the sukuk primary market. The sukuk assets available in the

secondary market have grown substantially since 2004 to reach USD 294.7 billion

outstanding as at 1H2014.

Assets under management of Islamic funds grew to USD 75.8 billion from USD 29.2 billion

in 2004, representing a CAGR of 10.8%. Despite relatively small market share as compared

to its banking and capital market counterparts, the takaful industry has recorded robust

double-digit growth rates in recent years. The industry’s contribution is to be estimated at

USD 21.4 billion in 1H2014 with an average annual growth of 15% between 2008-13

periods.

3.1 Shares of Islamic Banking Market in Muslim Majority Countries

Although almost all 56 nations OIC countries have introduced Islamic finance, the Middle

East, South-East Asia and South Asia Muslim majority countries have emerged as the leading

Islamic financial Industry centers. Iran and Sudan have adopted fully Shariah-complaint

financial systems. Based on 2012 data, among other major Muslim countries, Islamic banking

market share of total banking industry in Kuwait is above 60% followed by Saudi Arabia

(33%), Qatar, UAE, Malaysia and Bangladesh (20%) and Syria, Bahrain, Yemen and Jordan

(10%). Countries having below 10% Islamic banking market share include Egypt, Turkey,

Pakistan and Indonesia. List of Muslim majority countries having Islamic finance is shown in

Table-3.2.

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Table 3.2: Major Muslim countries offering Islamic FinanceName of Regions Name of Countries

Middle East Iran, Iraq, Kuwait, Saudi Arabia, Qatar, UAE, Bahrain, Oman, Lebanon,

Jordan, Syria, Yemen, Turkey

South East Asia Malaysia, Indonesia, Brunei

South Asia Bangladesh, Pakistan, Afghanistan, Maldives

Middle Asia/Europe Azerbaijan, Uzbekistan, Tajikistan, Kazakhstan, Albania, Cyprus

Africa Sudan, Egypt, Libya, Nigeria, Tunisia, Morocco, Algeria, Senegal,

Gambia, Djibouti, Niger, Guinea, Mauritania, MaliSource: IFSB, MIFC and Islamic Finance Development Report 2013, ICD Thomson Reuters

Iran is the top among all Muslim majority countries in terms of share of Global Islamic

Banking Assets securing 39.70% assets followed by Saudia Arabia (13.70%), Malaysia

(9.80%), UAE (9.10%) and Kuwait (9.0%).

Chart 3.1: Country Share of Global Islamic Banking Assets (2013)

Iran 39.70%

Saudi Arabia 13.70%

Malaysia 9.80%

UAE 9.10%

Kuwait 9.0%Others

5.60%Qatar 4.10%

Turkey 2.70%

Bahrain 2.30%

Indonesia 1.50%

Egypt 1.30%

Sudan 1.10%

Source: Islamic Financial Services Industry Stability Report 2015, IFSB, Malaysia.

3.2 Developments of Islamic finance in Western Countries and other Regions:

Though the Islamic finance industry has registered phenomenal growth in Muslim world due

mainly to religious factor, the non-Muslim people of the western world and other jurisdiction

have started to avail Islamic financial services motivated by commercial considerations. The

resilience nature of the Islamic finance and its immense potentials for expansion in the future

has drawn huge attention to non-Muslim customers within and beyond predominantly

Muslim markets and jurisdictions. These countries have undertaken measures to bring

changes to their legal and tax structure to facilitate the introduction of Islamic financial

products into their markets.

8

The United Kingdom (UK) is the leading country among the western world in using Islamic

financial products. The UK has established the west’s first fully fledged Shari’ah-compliant

retail bank and currently, the country has five Islamic banks. The other western countries like

France, Germany, Italy, Ireland, Luxemburg, Switzerland and USA are providing Islamic

financial services among their people (Di Mauro, F et. al. 2013). Asian large economies like

China, Hong Kong and Singapore are also increasingly offering Islamic financial services to

cater the demand of retail and corporate customers. Other jurisdictions like Russia, Japan and

India have also shown grater interest in Islamic finance (MIFC 2013).

Table 3.3: Major Non-Muslim Countries offering Islamic FinanceName of Regions Name of Countries

Europe UK, France, Germany, Italy, Ireland, Luxemburg, Switzerland, Denmark, Belgium, Russia

Asia China, Hong Kong, Singapore, Thailand, Philippines, Japan, India, Sri Lanka

Africa South Africa, KenyaAmerica USA, CanadaAustralia Australia, New Zealand

Source: IFSB, ECB, MIFC and Islamic Finance Development Report 2013, ICD Thomson Reuters

4. Current Status of Islamic Banking in Bangladesh2

4.1 Emergence and Present Number of Islamic Banks

The Islamic banking industry started its successful journey in Bangladesh through

establishment of the Islamic Bank Bangladesh Ltd. (IBBL) in 1983 which is the first interest-

free bank in Southeast Asia. Since its inception, the Islamic banking sector maintained robust

growth. After 1990s the Islamic banking sector gained further momentum and now it

accounts for more than one-fifth share of the entire banking system. As on 30th June 2014,

there are 56 commercial banks in Bangladesh of which 8 private sector banks (PCBs) have

been functioning as full-fledged Islamic Banks. In addition, 19 branches of 8 conventional

banks and 25 windows of 7 conventional banks are also offering Islamic banking services.

2 Sources of Data : Developments of Islamic Banking in Bangladesh, April-June, 2014 & Financial Stability Report, 2013 Bangladesh Bank

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4.2 Share and Structure of Deposits of Islamic Banks

Total deposits of the Islamic banks stood BDT 1335.61 billion at the end of June 2014 which

accounts 21 percent share of the entire banking industry. Among total deposits, 8 full-fledged

Islamic banks have mobilized deposits of BDT 1266.62 billion (94.8%), Islamic banking

branches of conventional banks have collected BDT 48.18 billion and Islamic banking

branches of conventional banks have gathered BDT 20.80 billion. Islamic Bank Bangladesh

Limited has the biggest share of deposits (39.36%) [chart-1], followed by EXIM Bank Ltd.

(13.01%), First Security Islami Bank Ltd. (12.17%), Al-Arafah Islami Bank Ltd. (12.10%),

Social Islamic Bank Ltd (8.08%), Shahjalal Islami Bank Ltd. (7.50%), Islami banking

branches (3.61%), Union Bank Ltd (1.71%), Islami banking windows (1.56%) and ICB

Islamic Bank Limited (0.89%).

Chart 4.1: Share of Deposits of all Islamic Banks (June 2014)

Source: Research Department, Bangladesh Bank

An analysis of different modes of deposits in the Islamic Banking sector reveals that

MudarabaTerm Deposits secured the highest position (53.12%) [chart-2] followed by

Mudaraba Savings Deposits (MSD) (18.03%), Mudaraba Special Savings (pension/profit)

Deposits (10.04%), Special Scheme Deposit (9.94%) and Current Account Deposits (4.55%).

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IBBL39.36%

ICB0.89%SIBL

8.08%

AL-Arafah12.10%

EXIM 13.01%

SJIBL7.50%

FSIBL12.17% Union

1.71%

Islami Banking Branches3.61%

Islami Banking Windows1.56%

Chart 4.2: Types of Deposits held by Islamic Banks (June 2014)

Mudaraba Savings Deposits18.03%

Mudaraba Special Notice Deposits

2.75%

Mudaraba Term Deposits53.12%Mudaraba Hajj Deposits

0.19%

Mudaraba Special Savings (Pension/Profit Deposits)

10.04%

Mudaraba Savings Bond1.44%

Cash Waqf Deposits0.05%

Special Scheme Deposits9.94%

Quard-e-Hassan Deposits0.03%

Al-Wadeea current Account Deposits4.55%

Other Deposits1.03%

Source: Research Department, Bangladesh Bank

4.3 Share and Structure of Investments of Islamic Banks:

Total amount of investments in Islamic Banking sector stood at BDT 1137.96 billion

at the end of June 2014 which represents 24 percent share of the whole banking industry.

Among total investments, 95.31 % are made by 8 Islamic banks, 3.31% by the scheduled

banks’ Islamic banking branches and the rest 1.38% is accumulated by the scheduled banks’

Islamic banking windows.

Chart 4.3: Share of Investments made by Islamic Banks (June 2014)

IBBL40.22%

ICB0.94%

SIBL8.30%AL-Arafah

12.89%

EXIM 13.99%

SJIBL7.56 %

FSIBL11.22%

Union1.46%

Islami Banking Branches3.31% Islami Banking Windows

1.38%

Source: Research Department, Bangladesh Bank

Islami Bank Bangladesh Ltd has accounted for the highest 39.04% share of investments

among all Islamic banks (chart-3) followed by EXIM bank Ltd. (13.99%), Al Arafah Islami

Bank Ltd. (12.89%), First Security Islami Bank Ltd (11.22%), Social Islami Bank Ltd

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(8.30%), Shahjalal Islami Bank (7.56%), Union Bank (1.46%) and ICB Islami Bank Ltd

(0.85%).

Islamic banks invest in all key sectors of the economy of Bangladesh. Investment in the

business has occupied the highest 28.95% share (chart-4). The next position is secured by

MSME (Micro, Small and Medium Enterprises) sector (24.67%) followed by Industrial

sector (23.11%), others (7.70%), Real Estate (7.40%), Agriculture (2.14%), Transportation

(1.51%), Electricity, Gas and Water supply (0.62%) and Poverty Reduction (0.42%).

Chart 4.4: Sector–wise Investment made by Islamic Banks (June 2014)

Agriculture2.14% Industry

23.11%

MSME27.96%

Communication and Transportation

1.51%

Real Estate7.40%

Business28.95%

Electricity, Gas and Water Supply0.62%

Poverty Reduction0.42%

Others7.70%

An analysis of mode-wise investment shows that Bai-Murabaha mode has occupied the

highest investments (44.06%) in June 2014 [chart-5] followed by Bai-Muajjal (24.90%),

HPSM (17.00%), Ijara & Ijara-bil-Bai (6.06%), others (4.27), Quard with Security (2.06%),

Musharaka (1.47%), Mudaraba (0.05%) and Bai-Istisna (0.14%).

Chart 4.5: Mode-wise Investment (June 2014)

Mudaraba0.05%

Musharaka1.47%

Bai-Murabaha44.06%Bai-Muajjal

24.90%

Bai-Istisnaa0.14%

HPSM17.00%

Ijara6.06%

Others4.27%

4.4 Number of Branches:

Total number of Islamic Bank branches (including Islamic branches of conventional banks

and windows) was 887 at the end of June 2014. Out of total branches of Islamic banks, 577

12

(65.05%) are located in the city and the remaining 310 (34.94%) are located in the rural

areas.

4.5 Developmental Roles of Islamic Banks

Islamic banks are playing crucial roles in mobilizing savings and external remittances and

turning those savings and remittances into investments which contributes a lot to promote

GDP and create jobs. By investing huge amount in trade finance, Islamic banks are

facilitating external trade to enhance our openness with global economy. More than 10

million account holders of Islamic banks (10% of the industry) are the glaring example of

how Islamic banks have become the banks of the people by playing their roles in financial

inclusion.

Table 4.1: Key Development Roles of Islamic Banks

Particulars 2010 2011 2012 2013Deposits Mobilization(in billion BDT)

594.43 740.29 939.16 1201.27

Financing (Investment) (in billion BDT)

563.12 688.95 860.50 1035.90

Remittances (in billion BDT) 220.90 237.12 301.60 325.50

Export Finance (in billion BDT) 164.52 195.06 211.20 224.30

Import Finance (in billion BDT) 282.38 324.90 311.96 336.40

Source: SBS, Bangladesh Bank.

4.6 Market Share of Islamic Banks

Although the Islamic banking industry has been growing faster than the conventional banks

banks, Shari'ah banks are still a minor proportion (grossly one-fifth) of the total banking

sector in Bangladesh. Compared with the overall banking industry, the combined share of

Islamic banks is 21 percent in deposits and 24 percent in investment as of end-December

2014.

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5. Comparative Performance of Islamic and Conventional Banks

5.1 Financial Performance:

The Islamic Banking industry is showing better financial performance in terms of financial indicators as revealed in ROA, ROE, IDR, CAR and other ratios.

Table 5.1: Selected Ratios of Islamic Banks and the Banking Sector in 2013Ratio Overall Banking Sector Islamic Banking SectorROA 0.90 0.89ROE 10.70 11.712Investment (Credit)-Deposit Ratio 71.18 85.1Classified Investment (Credit) to Investment 8.9 4.2Classified Investment (Credit) to Capital 59.8 39.88Capital Adequacy Ratio 11.50 12.07

Source: Financial Stability Report 2013, Bangladesh Bank

5.1.1 Profitability Ratios (ROE/ROA): The ROA of the Islamic banking industry stood

lower at o.89 compared with the overall banking industry of 0.90 in 2013. If one problem

bank is excluded from the list of Islamic banks, the other Islamic banks as a whole performed

better in terms of ROA as comaper to the overall banking industry. The ROE of Islamic

banking industry, on the other hand, stands at 11.71 percent, which is higher than that of the

overall banking industry ROE of 10.70 percent in 2013 indicating the earnings of Islamic

banks become higher compared to their equity position.

5.1.2 Liquidity: BB, in general, persuaded to maintain ADR of banks no higher than 85

percent for conventional banks and no higher than 90 percent for Shariah banks, taking into

consideration of their loanable funds after maintaining SLR of 19.0 percent and 11.5 percent

respectively. The Investment-Deposit Ratio (IDR) of full-fledged Islamic banks is 84.13

percent as of end- December 2013 while the ADR of banking industry stood 71.18 percent in

December 2013. The higher investment to deposit ratio (ADR) of Islamic banks indicate

better liquidity management.

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5.1.3 Classified investments to total investments

Islamic banks' classified investments to total investments ratio of 4.2 percent showed a

relatively better position as compared with 8.9 percent for the overall banking industry in

2013. The classified investment to capital ratio of 39.0 percent for Islamic banks as compared

with 59.8 percent for the overall banking industry.

5.1.4 Capital Adequacy Ratio: Given the minimum capital requirement (MCR) of 10

percent under the Basel-II accord for CY12, the significantly higher CARs of 6 Islamic banks

in the banking sector indicate both the financial strength and ample compliance of minimum

capital requirements (MCR). The stronger capital base ensures that Islamic banks are well

equipped to meet various kinds of shocks, if and when they arise.

Table 5.2: Islamic Banks' Capital Adequacy Ratio(CY12)CAR Number of Islamic Banks

Below 10.00% 1

10.00% to 11.00% 1

11.00% to 13.00% 2

>13.00% 4

Total 8Source: Financial Stability Report, 2013, Bangladesh Bank

5.2 Weighted Rate of Profit/interest on Deposits and Investments/Advances:

5.2.1 Weighted Rate of Profit/interest on Deposits:

The weighted rate of profit on deposits of Islamic Banks is 9.06 percent for all deposits which

is higher than private banks (8.69 percent) and industry average (8.63). The weighted rate of

profit on deposits of Islamic and other banks is shown in Table 5.3.

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Table 5.3: Weighted Rate of Profit/interest on Deposits

AS ON 30-06-2013

Banks All Deposit Savings Deposits

Special Notice

Deposits

Fixed Deposits

1 Year to Less than 2 Years

2 Year to Less than 3 Years

3 Years and

Above

All Banks 8.43 5.22 5.87 11.95 12.16 11.96 12.05State owned Banks 7.53 5.46 5.39 12.05 12.17 12.13 12.09

Private Banks (a+b) 8.69 4.95 6.22 11.9 12.16 11.54 11.98

Specialised Banks 9.52 6.46 5.39 12.18 12.23 11.88 12.37

Islamic Banks 9.06 5.38 4.79 11.76 12.05 10.66 11.63Source: Scheduled Bank Statistics, Bangladesh bank

5.2.2 Weighted Rate of Profit/interest on Investments/Advances:

The weighted rate of profit on investments of Islamic Banks is 13.54 percent for all

investments which is lower than private banks (14.62 percent) and industry average (13.61).

The weighted rate of profit on deposits of Islamic and other banks is shown in Table 5.4.

Table 5.4: Weighted Rate of Profit/interest on Investments/AdvancesAS ON 30-06-2013

Banks All advances

Agriculture Fishing & Forestry

IndustryWorking Capital Financing

Construction Transport And Communication

Trade

All Banks 13.61 9.62 13.75 14.07 13.47 14.96 14.36State owned Banks 10.87 9.14 11.63 11.79 5.94 13.66 11.5Private Banks 14.62 12.68 14.66 14.47 15.22 14.85 15.16Specialised Banks 11.15 8.84 12.66 13.79 14.65 17.48 14

Islamic Banks 13.54 10.1 14.18 13.65 14.67 14.37 15.14Source: Scheduled Bank Statistics, Bangladesh Bank

5.3 Concentration Trend of Investments

An analysis of sectoral investment reveals that large projects and trade financing get the lion

share of advances/investment disbursed by conventional and Islamic banks (Table 5.5). Small

projects, agricultural sector and poverty alleviation programs do not get fare share in

investments. Without the sustainable development of such sectors, it is not possible to

achieve the inclusive growth.

Table 5.5: Sectoral Analysis of Investment of Conventional Banks and Islamic banks

Economic Purposes2011 2012

SCBs PCBs SBs FCBs IBs All Banks SCBs PCB SBs FCB IBs All Banks

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s s1. Agriculture, Fishing & Forestry 6.38 1.43 48.52 1.77 2.37 5.59 6.31 0.95 41.61 2.08 0.95 4.852. Industry (Except W/C) 26.13 20.44 17.68 9.35 22.30 20.86 27.08 19.49 17.07 9.99 17.72 20.423. Working Capital 15.13 14.04 7.49 19.20 12.64 14.13 9.67 14.23 9.55 22.02 16.63 13.374. Construction 7.66 9.35 3.15 1.32 8.18 8.14 9.53 10.01 4.42 1.58 8.84 9.095. Transport and Communications 0.68 2.28 0.95 5.87 1.67 2.05 0.75 2.42 2.37 6.09 1.45 2.266. Trade 35.43 40.72 16.16 28.83 42.12 37.32 37.26 41.68 19.64 28.91 43.44 38.607. Others 8.58 11.74 6.05 33.67 10.71 11.92 9.40 11.22 5.33 29.33 10.97 11.40

Total 100 100 100 100 100 100 100 100 100 100 100 100Source: Scheduled Bank Statistics, Bangladesh Bank. Note: SCBs-State-owned Commercial banks. PCBs-Private Commercial banks. FCBs-Foreign Commercial banks

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6. Challenges of Islamic Banking in Bangladesh

i) Absence of Separate law: There is no separate act in regulating Islamic banking industry

in Bangladesh. Bangladesh Bank as a central bank exercises authority over Islamic banks

under some clauses incorporated in the Bank Company Act, 1991 (last amended in 2013)

which is used to control and supervise interest based traditional banks. Besides, the

operations of Islamic banks based on the principle of profit and loss sharing (PLS) actually

do not come fully under the jurisdiction of the existing civil laws. As a result, civil courts are

not sufficiently equipped to handle disputes created in the operations of Islamic Banking in

Bangladesh.

ii) Scarcity of Islamic money market instruments: An active money market plays vital role

in liquidity management of banks through short term tradable financial instruments. There are

limited sources of Shari'ah compliant funds in Bangladesh. Islamic banks can borrow funds

either from the Islamic inter-bank money market, which came into existence in 2012, or from

the "Islamic Investment Bond's Fund" issued by the Bangladesh Government. The absence of

adequate interest free securities has created difficulties in liquidity management. As a result,

Islamic banks can not invest in case of excess funds and do not avail liquidity support in case

of shortage.

iii) Predominance of Murabaha, Bai-muajjal and Ijara financing: The investment modes

of Islamic banks are heavily biased towards marked up and rental based modes of financing

(murabaha, bai-muajjal and ijara) which accounts for above 90% of total investment. The

Islamic ideal PLS based financial instruments like mudaraba and musharakah cover only

small amount of total investments made by Islamic banks.

iv) Small Share of Financing in social sectors: An analysis of investments made by Islamic

banks reveal that large projects/firms dominate heavily in Islamic banks industry in

Bangladesh. Micro, small and medium enterprises (MSMEs) and microfinance for poverty

alleviation programs do not get fair shares.

vii) Absence of Role in Government Project Financing: Bangladesh Government borrows

from conventional banks through treasury bills and bonds to finance many development

projects towards higher inclusive growth and jobs creation. Though Islamic banks pay huge

amount of fund to Government treasury as corporate and other tax regularly, they cannot

participate in public projects as financer due to lack of Shariah based instruments and legal

framework.

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vi) Paucity of Number of Islamic Insurance companies: The smooth advancement of

Islamic banking cannot sustain without the aid of Islamic insurance companies (takaful).

There are only three general takaful companies which are insufficient for Islamic banks to

protect investments against unforeseen hazards and catastrophes. In most cases relating to

insurance matters of trade and business, Islamic banks have to depend on interest based

insurance companies in absence of takaful.

vii) Scarcity of Skilled Human Resources: In Bangladesh, the Islamic banking industry

suffers badly from inadequacy of skilled human sources having better understanding the key

concepts of Shariah based financial services. Islamic bankers have bigger challenges than

those working in conventional banks as they have to acquire knowledge and expertise in

operations in banking as well as in Islamic Shariah relating to financial transactions.

viii) Absence of Islamic Financial Literacy program: Despite the growth of Islamic banks

over the last 30 years, many people, even old customers of Islamic banks are not familiar

with Shariah based deposit and investment products. Most Islamic banks have no financial

literacy program to educate the customers to have understanding the key concepts of Islamic

finance.

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7. Policy Options and Conclusions

Policy Options:

i. Standard and Appropriate Legal Framework: There are clearly differences

between traditional and Islamic financial industry in terms of products and legal

contracts. Besides, Islamic financial industry needs to give special attention to Shariah

aspects in financial operations. For sustainable development of the entire Islamic

finance Industry, it is imperative to develop proper legal framework for controlling,

guiding and supervising Islamic Banking.

ii. Maintaining International Standards: In order to maintain international standards,

Islamic banks must maintain regulatory standards set by AAOIFI and IFSB. It is also

necessary to formulate and implement unified definitions of mode of Fund Raising

and Investments to remove ambiguity.

iii. Rapid Development of other Segments of Islamic finance: Without proper

development of Micro Finance Institutes, Takaful and Islamic Capital Markets,

Islamic finance can not flourish as a complete industry capable to serve different

segments of the people of the country. To this end, MRA, IDRA and BSEC should

come forward to undertake necessary steps for smooth development of Islamic Micro

Finance Institutes, Takaful and Islamic Capital Markets.

iv. Promoting Investment under Musharaka and Mudaraba mode of Investment:

Since investments made by Islamic banks are miserably low (below 2%) in

Musharaka and Mudaraba, the ideal Islamic modes, Bangladesh Bank may provide

necessary directions to Islamic banks and Islamic branches/windows of conventional

bank for investing at least 10% of investable funds.

v. Increasing Investment in Agriculture and Social Sectors: Since Islamic banks

work on Shariah principle and one of the key objectives of Shariah principle is to

ensure welfare of the mass people, Islamic Banks should invest much (now below

2%, industry average 5%) in agriculture, and other social sectors like poverty

alleviation, education, skill developments and health sectors. Islamic banks should

spread their branches upto Union level (lowest administrative unit) for providing

necessary financial services for the rural people.

vi. Establishment of Supporting and Complementary Institutions: For building

Islamic Finance Industry as a solid and inclusive finance industry, there need to

undertake steps for establishing adequate number of supporting and complementary

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Institutions. These institutes include accounting and auditing firms, credit rating

agency and investment broker’s houses.

vii. Necessary Supports for Islamic Bank Branches/Windows of Conventional

Banks: Bangladesh Bank should pay special attention to remove the problems of

Islamic Bank Branches/Windows of Conventional Banks.

viii. Establishment of Separate 'Islamic Banking Department' at Bangladesh Bank: A

separate 'Islamic Banking Department' needs to be established at Bangladesh Bank to

formulate and implement policies for all the Islamic Banks and Islamic Bank

Branches/windows of Conventional Banks. The key functions of the department

would include issuance of license for opening of new bank and new

branches/windows of existing banks, fixing up capital adequacy requirements,

provisioning standard and reserve requirements, making review and drafting of

banking statutes, prescribing criteria for corporate governance, internal control and

risk management system of banks, determination of accounting standards and

disclosure requirements for banks, monitoring maintenance of statutory liquidity

requirements (CRR, SLR) of scheduled banks, and performance analysis and

monitoring of the scheduled banks on the basis of CAMELS.

ix. Formation of Central Shariah Supervisory Board at Bangladesh Bank: Since

compliance of Islamic Shariah is a part and parcel of Islamic banking, it is imperative

to establish a Central Shariah Supervisory Board at Bangladesh Bank to formulate and

implement uniform Shariah Governance Standards for all the Islamic Banks and

Islamic Bank Branches of Conventional Banks. This board should have a unique

balance of human resources comprising Islamic bankers, Islamic Jurists and Shariah

Auditors to oversee the activities of Shariah boards of Islamic banks. In this case,

Malaysian and other countries’ experiences can be explored.

x. Strengthening Islamic Banking Inspection Department: Bangladesh Bank needs to

adopt immediate measures to strengthen newly established Islamic Banking

Inspection Department (DBI 4) through recruitment, training and posting of officials

having clear understandings of principles and methods of Islamic banking.

xi. A Strong Islamic Finance Research Unit under Research Department:

Conducting Research on various key issues relating to Islamic finance, and

monitoring its growth trend and impacts pattern is prerequisites to reap fuller benefits

of Islamic finance. To this end, a ‘Islamic Finance Research Unit’ headed by a

Professional Islamic Finance Researcher under Research Department may be

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established at Bangladesh Bank. The key functions of this Department would include

(i) to collect data/information on Islamic finance and prepare monthly/quarterly and

annual report; (ii) to conduct comprehensive research in various fields of Islamic

Economics, finance and banking; (ii) to conduct field surveys on different Islamic

Banking and finance issues and prepare papers/reports on the basis of

data/information collected and surveys conducted. At present, an Islamic Banking

section is in operation under Research Department for nearly three decades. But it has

no regular sanctioned manpower; it is working in a limited scale.

xii. Establishment of Modern Islamic Finance Academy: In order to explore full

potentials of the Islamic finance, it is imperative to establish an IT based modern

Islamic Finance Academy for providing theoretical and practical training programs to

officials engaged in Islamic finance industry as regulators, supervisors and general

Islamic bankers. The proposed Academy would impart short and long training courses

ranging from certificate courses, Diploma, Graduate and PhD programs. The

Academy would also conduct survey/research programs on problems/prospects of

Islamic Finance in home and abroad, diversification of Islamic financial products,

Shariah aspects and other related issues. The Academy would also publish news

letters, bulletins and Journals regularly. One of key functions of the Academy would

conduct ‘Islamic Financial Literacy Program’ across the country in order to

disseminate clear concepts and remove misconceptions relating to Islamic finance.

The proposed academy should be established by contribution of each Islamic bank as

per market share.

xiii. Formation of Fund for Human Resources Development in Islamic Finance: To

attract and nurture talent people in the Islamic finance industry, there is urgent need to

establish ‘Fund for Human Resources Development in Islamic Finance’. This fund

should be formed based on contribution of each Islamic bank as per market share. The

fund may be used to provide scholarships for students pursuing Diploma/MS/PhD in

Islamic finance in home and abroad. Fifty percent of the fund may be allocated for

Islamic bankers who have already spent at least five years in the Islamic finance

industry.

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Conclusion:

Islamic banking has achieved significant growth in Bangladesh that belongs to 20 percent

share of the whole banking industry. However, investments under Mudaraba and Musharaka

are below 2 percents. Investment in socially desirable sectors like microenterprises, small

projects and agricultural sectors are only getting marginal shares in total investment. Islamic

banks are also facing challenges; among them major constraints include absence of separate

act, paucity of money and capital market instruments, and lack of skilled manpower.

Bangladesh has also tremendous potentials for further growth of Islamic banking as she has

vast population with increasing real per capita income and Muslim majority people.

Bangladesh may also bank on Islamic finance specially for financing large infrastructure

projects badly need to achieve higher GDP growth towards bringing poor people out of

poverty cycle. The ground has already been prepared by Islamic banks and its more than ten

million customers. The unlocking of unexplored immense potentials of the Islamic finance

industry depends on the appropriate legal framework, development of customized products

suitable for all segments of customer base, adoption of state-of-the-art technology and

committed skilled human resources.

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