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8/8/2019 IFI Instruments Pricing in Dual Banking System
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Mohammad Hafizi Hazran Md Zuki1000110
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Determining the Price of Islamic Financial
Instruments/Products in the Dual Banking System
Prepared By:
Mohammad Hafizi Hazran Md Zuki
1000110
July 11, 2010
June August 2010
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D e t e r m i n i n g t h e P r i c e o f I s l a m i c F i n a n c i a l
I n s t r u m e nt s / P r o d u c t s i n t h e D u a l B a n k i n g S y s t e m
Mohammad Hafizi Hazran Bin Md Zuki1
June 2010
Abstract
The dual banking system whereby Islamic banking exits on a parallel with conventional
banking system can bring stiff competition in term of giving competitive market price of
financial instruments. Islamic Financial Institutions need to offer better pricing for their
instruments to attract more customers using the Islamic financial instruments rather than
using the conventional products. In the dual banking system country such as Malaysia,
consumers have two alternatives whether to select either conventional or Islamic banking
instruments. The issues of benchmarking of Islamic instruments based on the conventional
counterpart are also evaluated in this paper. Furthermore, this paper is written to evaluate
the EONCAP Islamic Berhad, Home/House Financing-i BBA financing product on how
the product pricing is determined in the dual banking system environment.
1 The author currently enrolled in Charted Islamic Finance Professional (CIFP) program at International
Centre for Eductaion in Islamic Finance
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Table of Contents
Abstract
List of Figures/Tables
1.0Introduction2.0Literature review
2.1Dual Banking System2.2Conventional Banking vs. Islamic Banking2.3Monetary policies by Bank Negara2.4Based Lending Rate2.5Benchmark in the pricing of Islamic Financial Instruments
3.0Pricing of Financial Islamic instrument in the dual bankingsystem
3.1Home/House Financing-i in EONCAPIslamic Berhad3.2Modus Operandi for BBA in EONCAPIslamic3.3Pricing Methodology of BBA3.4Benchmark to determine profit in BBA
4.0Conclusion and findingsReferences
Pages
i
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4
5
5
6
8
10
11
12
13
13
16
17
19
20
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List of Figures
Figure 2.1: Monetary affect policies in term of economy and inflation
Figure 3.1: Home/House Financing-i product structure
Figure 3.2: Computation the Selling Price of Home/House Financing-i (BBA)
Figure 3.3: BBA Variable Rate Financing
List of Tables
Table 2.1: Differences between Islamic Banking and Conventional banking
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1.0IntroductionAs Islamic finance gradually gains distinction in the global financial view, never
ending debates have arose on whether Islamic or conventional banking products
would provide more value for money. Consumer always seeks for the instruments
that give them more value for money. In the dual banking system country such as
Malaysia, consumers have two alternatives whether to opt for conventional or
Islamic banking. In reality, what make consumers concern the most is whether the
banking products either from conventional or Islamic could provide them
competitive price and value added to their money.
In the past days, dealings such as the lending of cash were measured as a form of
charitable or social facility whereby the lender was expelled from making any
profit from his generosity. The borrower would have to pay the exact amount
borrowed which no more and no less. Conversely, in modern Islamic banking, such
exercise is no longer suitable because as commerce entities, Islamic banks need to
make a profit to stay in business and subsequently adding cost to the transaction.
As a substitute of charging interest from loans, these banks offer financing facilities
in other forms such as lease, sale and partnership. This allows Islamic financial
institutions to profit in ways that are permissible by Shariah law compared to
conventional banking system that totally based on riba transaction.
There are various banking products in the market in the dual banking system
country like Malaysia. Each of this financial institutions either Islamic or
conventional claimed that their products are cheaper that another product but in the
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nutshell the price of the banking product or the price competitiveness will depend
on various factors. This paperis written to examine that argument on what factors
that determining the price of Islamic financial instruments in the dual banking
system.
2.0Literature Review
In the literature review part, the overview of dual banking system model is
discussed. The discussion on how Islamic banking and conventional banking
system operate within the dual banking system is also analysed. This is followed by
an overview of difference between conventional banking and Islamic banking. The
monetary policies conducted by Bank Negara Malaysia are also discussed in this
literature review. Then this is followed by the studied on Base Lending Rate (BLR)
usage in dual banking system and finally the discussion on the benchmark of
pricing for the Islamic financial instruments are also reviewed comprehensively.
2.1Dual Banking SystemIslamic banking in Malaysia has one distinctive attribute that sets it
separately from the model applied in Iran and Pakistan. According to Rosly,
the Malaysia model is based on parallel or dual banking system, which
allows interest-based and interest-free banking to coexist and contend for
deposits and financing. Since Malaysians are multi-religious and multi-
cultural, Islamic banking is therefore expected to deal with situations in
which the demand for and supply of excess funds are no longer made on the
basis of trust alone but also on factors such as return on deposits, cost of
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financing and convenience. He also added that religious and non-religious
elements in the market segment of the Malaysian Islamic banking industry
is likely to affect performance as changes in market interest rates will likely
to affect Islamic bankers asset and liability management strategy (Rosly,
S.A 1999).
The capability of interest-free bankers to use Mudharabah as the main
profits generating products is not merely controlled by the legal related
problems but equally important is the problem of information cost related to
the financial structure of the banking firm. A support system is said to be
necessary to ensure that the Mudharabah instrument is effectively and
profitably implemented. It is rather meaningless to arrive at complex
formulas or techniques to generate a scheme of realistic profit sharing ratios
if there is no transparent system to help overcome the problems caused by
moral hazards and unhelpful selection. According to Rosly, the future of
Mudharabah-Musyarakah banking in this country is said to be dependant on
the ability of the interest-free banking system to produce such support
system (Rosly, S.A 1995).
2.2Conventional Banking vs. Islamic BankingThe comparison between Islamic banking and conventional banking can be
identifying in various difference ways. The major variation is that Islamic
Banking is based on Shariah groundwork. Thus, all dealing, contract,
business approach, product characteristic, asset utilization are derived from
the Shariah point of view which guide to the important diversity in many
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part of the operations as compared to the conventional banking. The
institution of Islamic bank is based on the Islamic faith and must stay
within the limits of Islamic Law or the Shariah in all of its activities and
deeds.
The central principles of an Islamic bank are:
i. The absence of interest-based (riba) transactions;ii. The prevention of economic activities involving domination (zulm)
iii. The prevention of economic activities involving speculation(gharar);
iv. The opposition of the production of goods and services whichcontradict the Islamic value (haram)
v. The introduction of an Islamic tax, zakat;
The main variation among Islamic and conventional banking is that Islamic
philosophy says that money itself has no fundamental value and forbid
people from profiting by lending it, without tolerant a level of risk which in
other words, interest or riba cannot be charged. Making money from money
is prohibited and wealth can only be generated through rightful trade and
investment. Any gain relating to this trading is shared between the person
providing the capital and the person providing the capability.
There are two major differences between Islamic banking and conventional
banking. Conventional banking practices are concerned with the elimination
of risk where as Islamic banks bear the risk whenever it involves in any
transaction. When Conventional banks involve in transaction with consumer
they do not take the liability only get the benefit from consumer in form of
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interest whereas Islamic banks bear all the liability when involve in
transaction with consumer. Getting out any benefit without bearing its
liability is declared unlawful in Islam. The differences between Islamic
banking and conventional banking are summarized in Table 2.1.
Conventional Banking Islamic Banking
The operational and regulationsfor the conventional banks are
based on human thinkingrationale.
The operational and regulationsfor the Islamic banks are based
on the philosophy ofIslamic Shariah.
The investor is guaranteed of a
predetermined rate of interest.
In distinction, Islamic Banking
promotes risk sharing betweeninvestor and entrepreneur.
Lending money and realization it
back with compounding interestis the fundamental function of the
conventional banks.
Participation in partnership
business is the fundamentalfunction of the Islamic banks.
Frequently it results in the bank's
own interest fitting prominent. Itmakes no effort to ensure growth
with equity.
It gives outstanding importance
to the public interest. Itsultimate aim is to ensure growth
with equity.
Interest-based commercial banks,
borrowing from the money
market is relatively easier.
For the Islamic banks, it must
be based on a Shariah approved
underlying transaction.
The conventional banks givegreater emphasis on credit-
worthiness of the clients.
The Islamic banks, on the otherhand, give greater emphasis on
the viability of the projects.
The status of a conventional
bank, in relation to its clients, is
that of creditor and debtors.
The status of Islamic bank in
relation to its clients is that of
partners, investors and trader,
buyer and seller.
Table 2.1: Differences between Islamic Banking and Conventional banking
2.3Monetary policies by Bank NegaraBank Negara Malaysia has a number of monetary instruments at its
discarding to infuse and extract funds to influence the level of interest rates
in the financial environment that operate dual banking system. Examples of
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these instruments would include the purchase and sale of Bank Negara
Malaysia and Malaysian Government papers, changes in the statutory
reserve requirements and direct lending and borrowing in the interbank
market. Furthermore, The Overnight Policy Rate (OPR) will also be the
gauge of the monetary policy position. The OPR will have dual roles which
are act as a signalling device to designate the monetary policy position and
as a mark rate for the day-to-day liquidity operations of the Central Bank.
Any change in the monetary policy position would be signalled by the
adjusted value in the OPR. It will serve as the primary reference rate in
determining other market rates. To replicate the unchanged position of
monetary policy, the OPR will be set at the current interbank overnight rate.
Overnight rate as the solitary operating target monetary operations of BNM
will target the overnight interbank rate. Liquidity management will aim at
ensuring the appropriate level of liquidity that would influence the
overnight interbank rate to move close to the OPR.
Liquidity operations will also be conducted at other maturities but without
targeting a specific interest rate level. Therefore, interbank interest rates at
other maturities would be market determined, reflecting overall demand and
supply conditions in the money market as well as interest rate expectations.
Introduction of Overnight Operating Corridor and Standing Facilities is to
minimize the excessive volatility in the overnight rate; Bank Negara
Malaysia will specify a corridor around the OPR. The corridor is set at
more or less than 25 basis points around the OPR. Day-to-day liquidity
operations will aim to hold the overnight rate close to the announced OPR.
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A standing facility is introduced to ensure that the overnight interbank rate
fluctuates within this corridor by providing a lending facility at the upper
limit of the operating band and a deposit facility at the lower limit of the
operating band. Market participants will transact among interbank
institutions at a rate within the operating band to meet their short-term
liquidity needs before utilising the standing facility. This policies introduce
is said by BNM as an advantage to both conventional and Islamic banking
system.
2.4Based Lending RateBase Lending Rate (BLR) is a lowest amount interest rate deliberate by
financial institutions based on a principle which takes into consideration the
institutions cost of funds and other administrative costs. This BLR is
defined by central bank, Bank Negara Malaysia (BNM). The Overnight
Economic
Growth/Inflation
Consumer &BusinessSpending
BankReserves(Liquidity)
Monetary Operation
Money supply
Interest rates
ExchangeRates
Bank NegaraMalaysia
Figure 2.1: Monetary affect policies in term of economy and inflation
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Policy Rate (OPR) from Bank Negara Malaysia is indication or benchmark
for the banks in BLR adjustments, but there might be at variance from bank
to others bank. At the global money market down turn, BLR will get lower
and if the money market on uptrend, it will correspondence upward. It is
prudently and timely to consider take up finance loan and start to own your
property at the lowest BLR rates. From the evidence, it shows that the
utmost BLR Malaysia ever achieved is 12.27% in year 1998 and the lowest
BLR is 5.55% in year 2009. The average is 8.1%.
2.5Benchmark in the Pricing of Islamic Financial InstrumentsIn the recent years, the Islamic finance institutions (IFI) have accomplished
huge expansion and developed from position commerce to a practical
substitute for global financial architecture. However, IFI still relies on
conventional finance benchmarks, such as LIBOR, to determine its own
cost of funds, and hence its return to financial investments.
At the present time, IFI uses the interest rate as the benchmark for Islamic
finance products. Profit rates charged by IFIs are basically replicate of the
market interest rates. This practice, although dispirited, is basically
accepted in Islamic finance as the interest rate is used purely as a
benchmark only. Nonetheless, any reference to the interest rate should be
minimised and therefore the need for providing an Islamic pricing
benchmark for IFI should be emphasised. Rosylin (2009) attempted not
only to implement a analytical approach to model retail assets rental values
to be benchmarked in opposition to the conventional interest rates
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(KLIBOR, LIBOR, and EURIBOR), but also proposed the use of the
balance property rental values as alternatives to the current conventional
interest rates
3.0Pricing of Islamic Financial Instrument in Dual Banking System
The dual banking structure of Malaysia is exclusively categorized among other
countries as a securely governed lawful system, where split regulatory systems for
Islamic banks and other conventional banks are operating side by side. In Malaysia,
Islamic banking was formally set up in 1983 by virtue of the Islamic Banking Act
1983. Consequently, the Interest-Free Banking Scheme was introduced in 1993 to
lodge a full-fledged Islamic banking system on parallel basis with a conventional
banking system. Dual banking systems are juristically criticized for not totally
eliminating interest-rate financing, which is prohibited in Islamic jurisprudence,
but duality has its own sensible qualities over the full- fledged single Islamic
banking systems.
Rigid competition between Islamic products and conventional instruments in the
dual financial market has effectively resulted in Islamic banking products that are
more sophisticated and have a more diversified range than those offered in single
Islamic systems. The challenge of surviving in such competitive markets requires
innovative efforts in designing Islamic financial products to satisfy conventional
needs of sophisticated customers, which, however, have to be clearly guided by
Shariah principles to ensure Islamic legitimacy. In surviving in the competitive
market a good pricing mechanism in the Islamic instruments is needed.
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This paper will evaluate the pricing of BBA contract in Home/House Financing-i
from EONCAP Islamic Bank Berhad. Making a loan under under conventional
banking is one of the most common ways to own a house but in Islamic banking
there are BBA financing for customer to own a house.
3.1Home/House Financing-i from EONCAP Islamic Bank Berhad2
Ownership a house is now made simple for all with the Home/House
Financing-i (BBA) from EONCAP Islamic Bank Berhad. This product is
based on Bai Bithaman Ajil (BBA) contract, Home/House Financing-i
(BBA) lets the customer purchase their dream home after determining the
customer needs. The property will then be sold to the customer at a pre-
agreed price, which includes EONCAP Islamic Banks purchase price and
profit margin. There are three packages available for these products which
are:
i. Fixed monthly obligation during progressive releases to facilitatethe customer to for future financial planning.
ii. Variable/floating rate home financing based on the association of theBase Financing Rate (BFR) with capped at an agreed ceiling rate.
iii. Customer with eligible condition is entitle for Year End AnnualHoliday payment
3.2Modus operandi of BBA at EONCAP IslamicThe Home/House Financing-i is an Islamic financing facility, which is
based on the Shariah concept of Al Bai Bithaman Ajil (BBA). It is a
2Available at internet
http://www.eonbank.com.my/islamic/financing/home_house_financing_i.shtml
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contract of deferred payment sale like the sale of goods on deferred
payment basis at an agreed selling price, which includes a profit margin
decided by both parties. Profit in this context is justified since it is derived
from the buying and selling transaction as divergent to interests accruing
from the principal lent out. The structured of this product is illustrated in
Figure 3.1.
BBA refers to the sale of goods on a deferred payment basis at a marked-up
credit price, which includes a profit margin agreed by both parties. The
packing involves a combination of sales, profit margin and deferment,
conducted between two parties. The sales between the customer and the
bank (bai); a cost plus a sale including a stated profit margin (murabahah);
a deferred payment (al-ajal); and involves one party selling an asset at a
CustomerHome-buyer
SellerDeveloper
EONCAP Islamic
Customer sells house toIFI for the cost offinancing (SellingPrice), to settle the
balance with thedeveloper
Customer immediatelybuys the house back fromthe IFI including the IFIsfinancing and its profit
margin (Purchase Price), asa deferred credit price
Developer sells
house and home-buyer pays a deposit
to seller
Pays balance to sellerwho then transferstitle to buyer
1
2
4
Figure3.1: Home/House Financing-i product structure
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higher deferred price but buys it immediately for a lower cash price( bai al-
inah) as reflected in the financing of the new home as per Figure 3.1.
The process of BBA involves a Sale & Purchase Agreement between the
buyer and the original seller (developer) of the house, which includes a
payment of a deposit to the seller. Subsequently, a Property Purchase
Agreement (PPA) involves the bank agreeing to buy the house from the
customer for the cost of the financing followed by a Property Sale
Agreement (PSA) is signed immediately afterwards with bank selling the
property back to the customer including its profit margin. Subsequently, the
transfer of Title occurs between the original seller (developer) and the buyer
(customer). The buyer then takes out a famliy takaful mortgage plan for the
value of the banks Purchase price(financing). Whetter the calculation
includes a fixed or variable rate, the mechanics reveal that the financing is
the same as monthly reducing balance or constant rate return
The main characteristics of this product is all the mechanism to determine
the selling price have to be fixed because the selling price has to be fixed at
the time the contract is made. Hence, the profit rate for the BBA financing
is fixed and constant throughout the period of financing. The BBA
financing design is not tagged to the BLR. Thus, the instalments will be
fixed according to the rates declared upon agreement. The selling price
formula for Home/House Finanicng-i is illustrated in Figure 3.2:
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3.3Price Methodology of BBA by EONCAP IslamicA common conventional housing loan is set on the basis of debtor and
creditor relationship. Whereby, the sum of loan is being charged interest is
normally quoted at a certain percentage above the Base Lending Rate
(BLR) over the loan period which repayable in periodic instalment. The
BLR will fluctuate up or down and it will affect the total loan cost.
Concurrently, amount outstanding in conventional loans are normally
capitalized. However, under the Islamic banking scheme, since the BBA
concept is being applied, a seller-buyer relationship will be established and
the selling price is fixed upfront. The sales price is then repaid in periodic
instalments and the agreed instalments will remain fixed throughout the
Selling price = (monthly instalment x number of financing months) + grace
period profit (if any).
Example:
Financing amount: RM48,000.00
Profit rate: 4%
Financing period: 20 years
Installment per month: RM360.00
Selling price = (RM360.00 X (20 X 12)) + 0 = RM86,400.00
Figure 3.2: Computation the Selling Price of Home/House Financing-i (BBA)
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financing period. As such, a customers interest rate risk is eliminated.
Furthermore, amount outstanding will not be capitalized.
3.4Benchmark to determine profit in BBAInstead of using fixed rate financing mechanism in determines the profit for
BBA contract the variable rate financing is also offered by the Home/House
Financing-i. The variable rate financing is also offered by the bank that
enable the Islamic financial institutions which operate in a dual banking
environment to constantly match the current market financing rate in order
to provide matching returns to their depositors and thereby alleviating any
mismatch risk. By doing this, the EONCAP Islamic is able to receive
varying income streams from it financing activities, which will be
distributed to the depositors at a more competitive rate.
The floating rate financing is an improvement to the existing BBA
financing concept which is fixed-rate in nature. Under the BBA, the selling
price of the asset sold to the purchaser on deferred terms would be fixed at a
profit rate known as the ceiling profit rate. The ceiling rate is higher than
the profit rate under the fixed rate BBA financing where in theory the
contractual selling price and instalments would be higher. However, rebate
known as ibra which mean a waiver of right to claim unearned profit is
required to be granted at every instalment for example on a monthly basis
in order order to reduce the monthly instalments to match the current
market level as illustrated in Figure 3.3.
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In practice, the rebate would be varied so that the effective profit rate
(ceiling profit rate less rebate) reflects the fluctuating market financing rate.
Accordingly, the bank would be able to raise their financing rate when there
is a rise in market rate, hence, it can give better returns to its depositors.
The ceiling rate would provide some comfort to the customer that the
effective profit rate would be capped at that rate. There are many literatures
suggested Islamic banks to evade conventional rate used in pricing Shariah
products in the deficiency of a benchmark Islamic rate. This is due to the
benchmarking that will expose it products to the instability in conventional
financial markets. Iraj Toutounchian (2009) once recommended that the
weighted average of the internal rate of return is uses as benchmark in
formative the Islamic banks margin over profit. Furthermore, Taqi Usmani
(2005) also commented on this issue with his idea of substitute which is the
Islamic banks and the financial institutions should struggle for developing
their own benchmark. This can be done by creating their own inter-bank
Figure 3.3: BBA Variable Rate Financing
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market base on Islamic principles. The purpose can be achieved by creating
a common pool which invests in asset-backed instruments like musharakah
or ijarah.
4.0Conclusion and Findings
As conclusion, in order for the Islamic Financial Institutions develop to be
privileged in the financial industry, there is a need to re-evaluate their marketing
strategies, especially their pricing strategy. In Home/House Financing-i BBA
product from EONCAP Islamic Berhad, the practise of offering either fixed or
floating rate BBA financing is merely to attract different segments of customer.
Benchmarking is essential for IFIs to be at par with others conventional
counterpart. Hence, a proper and fresh benchmarking parameters need to be
introduced to facilitate IFIs in evaluating their relative competence, identifying the
performance gaps and formulating strategies to improve and deliver the best
results. Therefore, it is essential for IFIs to strengthen research and development
efforts in Islamic financial products innovation. This will involve Islamic banking
institutions to consider the opportunity of forming strategic alliances to tap the
research and development expertise for development outside the banking industry
in order to create the range of Islamic financial products capable of meeting the
consumer requirements and preferences.
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References
Ayub, Muhammad. (2008). Understanding Islamic finance. Hoboken, NJ: John
Wiley & Sons.
Bank Negara Malaysia. The Financial Sector Masterplan: Islamic Financial
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Reterived 5 July 2010, at http://www.bnm.gov.my/files/publication/ar/en/2003/
cp05_003_whitebox_intro.pdf
Chong Kok Loong. (2009)Differences between Musharakah Mutanaqisah and al-
Bay Bithaman Ajil. Paper presented at The 3rd Islamic Economics
Conference 2009. (Unpublished).
EONCAP Islamic web site. (2009). Home /House Financing-i (BBA).
Retrieved 30 June 2010, at
http://www.eonbank.com.my/islamic/financing/home_house_financing_i.shtm
Hamdan Haji Idris(2010), Deposit & Financing Operations of Islamic Banks
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Banking Act 1983 (IBA)
Radiah Abdul Kader and Yap Kok Leong. (2009). The Impact of Interest Rate
Changes on Islamic Bank Financing. International Review of Business
Research Papers. 5(3). p.
Rosly, S.A. (1999) Al-Bai-Bithman Ajil financing: Impacts on Islamic Banking
performance. Journals for Kulliyah of Economics and Management Science.
Edition of Semester 2 March 1999, pp36.
Usmani, Muhammad Taqi. (2005). An introduction to Islamic finance.
(Special edition.). Karachi, Pakistan: Maktaba Ma'ariful Qur'an.