Reposted from the web

Summary: This Muslim knowledge guide revisits a paper on Islamic banking, focusing on Islamic subsidiaries of conventional banks in Malaysia, Sharia compliance, profit maximization, murabaha, riba, manager incentives, banking structure, and whether Islamic banks are truly Islamic in practice.

This is another article I translated that critiques Islamic finance. The previous ones got a good response and made many readers think. If you read those, you will see that the contradictions and struggles of so-called Islamic finance were already discussed by scholars decades ago. Solutions exist, but we know very little about them. This has a lot to do with the stance of the people who control the narrative.



Original title: HOW ‘ISLAMIC’ IS ISLAMIC BANKING? A REVISIT

Authors: Eliza Nor, Anwar Allah Pitchi, and Muhammad Usman. It was originally published in the International Journal of Accounting, Finance and Business. All three are from the Universiti Sains Malaysia, and the paper was published in 2020.
Main text: Literature widely suggests that Islamic banks and conventional banks do not differ much in terms of regulation, operational expectations, operational dynamics, and organizational structure (Asutay, 2007; Siddiqi, 1999). Considering this argument, this paper tries to discuss these issues by focusing specifically on the Islamic subsidiaries of conventional banks in Malaysia. The establishment of Islamic subsidiaries by conventional parent banks has raised many unresolved questions.

Based on an extensive review of theoretical and empirical literature related to Islamic banking and Islamic economics, this study identifies three major challenges facing Islamic banks. These challenges may cause the implementation of Sharia to be limited to a minimum scope.

The first challenge is the different goals between the conventional parent bank and its Islamic subsidiary. The main goal of a conventional parent bank is profit maximization (maximizing shareholder wealth), while the main goal of an Islamic subsidiary (in theory) is to comply with Sharia regulations (profit maximization is only secondary). Managers who are supposed to execute and follow Sharia rulings still need to follow instructions from the senior management of the conventional parent bank.

The second challenge is the profit-maximization motive of Islamic banks. Since an Islamic subsidiary is a subset of a traditional parent bank, its goals must align with those of the parent company.

Finally, if managers lack a deep background in Sharia law, their background can become an obstacle during the Sharia compliance process.

Islamic finance and banking started nearly forty years ago. Even today, despite many ways for Sharia scholars and practitioners to discuss ongoing issues, many unresolved questions and controversies remain around the industry, along with new problems that emerge alongside the development of Islamic banking and finance. One main reason why issues remain unresolved is that there is no clear distinction between Islamic banks and traditional banks, as both systems coexist in the same economy. Although Islamic finance was founded back in the time of the Prophet Muhammad, it has developed much more slowly than traditional finance. Traditional banking and finance have been accepted and practiced by most countries in the world for centuries, so the development of Islamic finance is to some extent benchmarked against traditional banking. In countries like Malaysia where Islamic banks exist, coexistence with traditional banks is almost unavoidable because these banks were originally established as traditional banks. Islamic banking windows were opened to meet the growing public demand and interest in Islamic banking products.

The successful implementation of the Islamic banking system in the Middle East encouraged local consortiums to establish Islamic banking in Malaysia. Therefore, in 1983, Malaysia enacted the Islamic Banking Act and established the first full-fledged Islamic bank, Bank Islam Malaysia. In 1999, the second Islamic bank, Bank Muamalat, was established. To this day, these are the only full-fledged local Islamic banks in Malaysia. Other local Islamic banks operate as subsidiaries of traditional parent companies, including Affin Islamic Bank Berhad; Alliance Islamic Bank Berhad; AmBank Islamic Berhad; CIMB Islamic Bank Berhad; Maybank Islamic Berhad, Public Islamic Bank Berhad; and RHB Islamic Bank Berhad.

In 1993, the Central Bank of Malaysia (Bank Negara Malaysia) gave traditional banks the option to open Islamic windows. These windows offered customers banking products that follow Sharia law through their existing traditional branches. As a result, 21 Islamic banking windows were set up by their traditional bank parent companies. In 2002, the Central Bank of Malaysia allowed traditional banks to open Islamic subsidiaries to replace their existing Islamic windows. These subsidiaries are governed by the Islamic Banking Act of 1983 (Mohamed Ariff, 2017).

Over time, issues related to Islamic banking operations have grown because of conflicts between Sharia goals and commercial goals. The former is built around Islamic concepts, while the latter is built on a capitalist economy. The task of Sharia scholars is to ensure that Islamic banks follow the goals of Sharia law. On the other hand, managers are the people responsible for carrying out Sharia rulings. At the same time, managers also have a duty to meet the business goals set by the board of directors. Because of this, managers are stuck in the middle between reaching Sharia goals and business goals. This conflict can lead to Islamic banks failing to follow Sharia. Beyond the differences between business goals and Sharia goals, the backgrounds of managers and staff also play a big role in making sure Islamic banks follow Sharia.

Since Islamic banking and finance began, the issues and challenges facing the industry have been widely debated by scholars, professionals, and regulators around the world. Many documents discuss how Islamic banking products are similar to traditional banking products (for example, see Dusuki & Abozaid (2007); Kuran (2004); Siddiqi (2006); Yousef (2004)). On the other hand, issues regarding Islamic banking operations have received very little attention in the literature. Some argue that there is not much difference between Islamic banks and traditional banks when it comes to regulation, operational expectations, operational dynamics, and organizational structure (Asutay, 2007); Siddiqi, 1999). To fill this gap in the literature, this article focuses on the operations of Islamic subsidiaries of conventional banks based on a newly developed conceptual framework.

There are two reasons for choosing Islamic subsidiaries of conventional banks. First, setting up Islamic subsidiaries by conventional banks has become a popular practice not only in Malaysia but also worldwide. Since the birth of Islamic finance nearly forty years ago, Islamic banking has become a profitable business. Many conventional banks have tried to seize this opportunity by establishing their own Islamic subsidiaries. As mentioned above, most Islamic banks in Malaysia exist as subsidiaries of conventional banks. Second, issues and controversies surrounding Islamic subsidiaries are expected to be more severe compared to established Islamic banks, because the former are under the control of non-Islamic conventional banks. On the other hand, for established Islamic banks, issues or conflicts related to Sharia may be less obvious because these banks exist independently and their decision-making processes are not influenced by a conventional parent bank.

Islamic Economics and Capitalist Economics

Before discussing issues related to Islamic banking, it is important to emphasize the differences between capitalist economics and Islamic economics, because Islamic economics and finance are only a small part of the larger capitalist economy.

Therefore, the influence of the former on Islamic economic and financial activities is almost inevitable, as the entire world is governed by capitalist economics. The difference between the two is only clear in theory. In reality, daily activities in both Muslim and non-Muslim countries are influenced by the capitalist economy.

The capitalist economy is built on a neoclassical framework that focuses on individual self-maximization while ignoring the maximization of social welfare (Asutay, 2007, p. 168). This approach contradicts the teachings of Islamic economics, which emphasize a balance between self-interest and social welfare.

Muhammad Zahid (2015) argues that the Muslim world has become a supporter of interest (riba) and secularism, which is the separation of daily life, activities, and education from religion. Muslims have also consistently supported the fiat currency and fractional reserve systems introduced by the Western world, which resulted from the fall of the Ottoman Caliphate in Turkey in 1923, the rise of the Western world, and the spread of secular ideologies.

The differences between capitalist economics and Islamic economics are obvious; the former emphasizes individualism, while the latter focuses on the welfare of both the individual and the entire society. Islamic economics also considers life in the afterlife, whereas capitalist economics only focuses on worldly life.

Similarities between Islamic banks and traditional banks: Islamic banks have two main goals: profitability and social objectives. However, profitability should not be the only goal, because Islamic banks must meet the social objectives set by the goals of Islamic law (Maqasid al Shariah), which is the fair distribution and circulation of wealth. Wealth circulation means that funds in society should flow from the rich (surplus sector) to the poor (deficit sector). Warde (2000, pp. 174-175) summarizes the functions and roles of Islamic banks in society as follows (based on the Islamic Banking Handbook, Vol. 6, p. 293):

(1) Broad social and economic benefits: Investment policies must focus on these sectors: agriculture, housing, and health services.

(2) Create job opportunities, focusing on promising economic sectors like agriculture, manufacturing, and technology-intensive activities.

(3) Promote and encourage entrepreneurship: Banks must prioritize small businesses through profit and loss sharing (PLS) mechanisms like mudarabah and musharakah.

(4) Promote social justice, equality, and poverty alleviation.

(5) Regional distribution of investments: (a) Direct funds to areas that lack investment. (b) Invest savings primarily in areas where savings were mobilized, so that people benefit from their own savings.

Based on the functions and roles of Islamic banks mentioned above, it is clear that Islamic banks should provide financing to entrepreneurs starting new businesses in sectors that use new technologies, such as information technology, biotechnology, and nanotechnology. However, these entrepreneurs may lack experience and a track record because their businesses are small and new. They may need a lot of capital to expand, so they might seek funding from Islamic banks. However, due to the nature of these businesses, these entrepreneurs may lack the collateral to offer banks. Entrepreneurs with new businesses, lacking a track record and collateral, are likely to be excluded from getting financing because their businesses are risky and have a high chance of failure. Therefore, their applications might be rejected. This leads to the problem of financial discrimination by Islamic banks. According to Asutay (2007, p. 177), financial discrimination in personal banking has become a major issue. When comparing debt financing in both types of banking, entrepreneurs rejected by traditional banks may receive the same treatment from Islamic banks.

In theory, Islamic banks should provide equity-based financing, such as profit-sharing partnership (mudarabah) and joint venture (musharakah) (M&M). Both mudarabah and musharakah are based on profit and loss sharing (PLS), where both the financier and the entrepreneur share profits and losses according to a pre-agreed ratio. These types of financing are suitable for entrepreneurs with new businesses. However, in practice, Islamic banks have been avoiding M&M financing. Evidence provided by Aggarwal and Yousef (2000), Iqbal and Molyneux (2005), Hasan (2007), and Nagaoke (2007) shows that Islamic banks rarely provide long-term financing to entrepreneurs seeking funds. Asutay (2007) argues that equity financing contributes more to economic growth than debt financing because the former is long-term. The fact that Islamic banks avoid equity financing suggests they are not particularly interested in economic development and social welfare. Islamic banks are more interested in providing financing with fixed returns, such as cost-plus financing (murabaha), deferred payment sale (bay bithaman ajil), and leasing (ijarah), rather than offering PLS-type products.

On the other hand, Islamic banks often operate in ways that mimic traditional banks, where (1) both avoid providing financing to entrepreneurs with risky businesses, and (2) both rely heavily on debt financing to ensure fixed returns (Warde, 2000, p. 22). Therefore, the goal of reaching deep into rural areas to serve them has not been achieved. Most evidence highlights that Islamic banks prefer to invest in short-term commercial deals rather than the manufacturing or agricultural sectors (Warde, 2000, p. 175). As Asutay (2007) and Warde (2000) point out, the main sectors Islamic banks should focus on are agriculture, manufacturing, and technology-intensive industries. Traditional banks are built on a fractional reserve system, which expands the money supply by multiplying loans. In this system, commercial banks use excess reserves from money deposited by savers to make a profit by charging interest to borrowers (for example, see Mishkin, 2016). This system goes against Islamic teachings because the profit comes from riba, and the bank uses other people's money—the money of the savers—to earn that profit.

Islamic banks, just like traditional banks, create money through debt financing (Zaman, 2020). The effects caused by credit expansion in traditional banks and Islamic banks are almost the same. This credit expansion can be linked to artificial scarcity (due to greed and self-interest), trade distortions (due to wealth accumulation, inflation, and the financialization of capital), and inherent boom-and-bust cycles (business cycles); ecological destruction (deforestation) and wealth polarization (wealth concentrated in the hands of a few); income inequality. Because of the nature of the money supply, as global debt increases, the business interests served by that debt allow the rich to become even wealthier. Over the past decade, more and more wealth has been concentrated in the hands of fewer and fewer people (Jha, 2013, pp. 356-359). Sabirzyanov and Hashim (2015) argue that Islamic banking and finance create bubble economies through debt financing under a fractional reserve system. Like traditional banks, Islamic banks support the expansion of the money supply, which leads to economic inflation. Even though price levels rise, the GDP growth rate does not change because the actual production in the economy likely stays the same.

Empirical evidence supports the argument that there is no major difference between Islamic banks and traditional banks. Chong and Liu (2009) empirically studied the differences between Islamic and traditional banks and found that Islamic banks do not differ much from traditional banking operations. In terms of assets in the Islamic banking industry, only a small portion of financing is based on profit and loss sharing (PLS) principles. In Malaysia, the vast majority of Islamic bank financing is still based on non-PLS models allowed by Sharia, but these ignore the spirit of prohibiting usury. Their research shows that in practice, Islamic deposits are not interest-free. One possible explanation for why Islamic deposits are not interest-free is that depositors' funds are mainly invested in non-PLS financing in practice. Due to increased competition from the traditional banking industry, the return rates on Islamic deposit accounts are linked to the return rates of traditional bank deposits. They concluded that the Islamic banking practiced in Malaysia today is similar to traditional banking, so the benefits of Islamic banking only exist in theory.

In Pakistan, research has also been conducted on the similarities between Islamic banks and traditional banks. Hanif (2016) chose five contracts or products to analyze: deposits, cost-plus financing (Murabaha), leasing (Ijarah), diminishing partnership (Reducing Musharaka), and Islamic bonds (Sukuk). The results show that even though these financial contracts look at legal forms, their economic substance matches traditional banking more closely. The study found that despite philosophical differences, the financial results of the Islamic finance system match traditional banking. This happens mainly because pricing is linked to the interbank offered rate (Islamic Bank OR), which ignores market mechanisms or the actual price of goods and services provided. Some also argue that putting Sharia-based financial contracts into practice is more demanding than what the contracts themselves require. Islamic banks prefer Sharia-compliant financial contracts because they are similar to traditional financial products (Hanif, 2018). A recent study on how customers perceive Islamic banks in Malaysia found that most people surveyed do not think Islamic banking is fully compliant with Sharia. This shows how important it is to implement a profit-and-loss sharing (PLS) system in the current financial setup. The results also show there is not much difference between Islamic banks and traditional banks, as both focus on efficiency and keeping their current services running (Rahmi, Azma, Obad, Zaim, and Rahman, 2020).

Evidence shows that Islamic banks currently fail to meet all the requirements set by the El Hawary four-part classification (El Hawary, Grais, and Iqbal, 2004: 5): (1) risk sharing (financial deals must reflect a balanced risk and reward distribution for everyone involved); (2) materiality (financial deals must be linked, directly or indirectly, to real economic transactions); (3) no exploitation (financial deals should not lead to any party involved being exploited); (4) no funding for sinful activities (such as producing alcoholic drinks). Therefore, the argument that Islamic banks offer a different alternative to traditional financing is not supported, because there is no real difference between Islamic banks and traditional banks (Khan, 2010). If Islamic banks do not operate much differently from traditional banks in reality, they will fail to reach their original goals of promoting social justice and equality or reducing poverty if they do not direct funds to the people who need them.

In terms of financing, Islamic banks limit their social role to zakat and other charitable activities like religious endowments (waqaf) and voluntary charity (sadaqah), which overlooks economic development and social justice. Even though the Islamic banking industry has been growing worldwide, the lives of Muslim people have not improved much. From the early days, it was clear that Islamic banks should not be driven by profit maximization, but should instead provide socio-economic benefits to their communities (Warde, 2000, p. 153). In practice, Islamic banks tend to make profit maximization their main goal, which is the same as the goal of traditional banks. In theory, the purpose and foundation for establishing Islamic financial institutions are completely different from those of traditional financial institutions. Islamic banks should follow the goals of Islamic law (maqasid al-shariah) regarding the protection of wealth. According to Islamic law rulings, five dimensions of public welfare (maslahah) must be protected in Muslim society: faith, life, intellect, prosperity, and property (Khairul Mukminin, 2018).

Laldin and Furqani (2012:4) define the goals of Islamic law (maqasid al-shariah) as follows: '...as a way of life, Islam forms standards, guidelines, values, and directions based on divine revelation (wahi) to be applied in daily life to solve human problems and guide the direction of human life.' The principles of goals (maqasid) and public welfare (maslahah) cannot and must not contradict the Quran and the Hadith, as both are the core of all other principles and rules. However, in the current situation, the interpretation of public welfare (maslahah) comes only from practical methods and reasoning, rather than from the Quran and the Hadith. Therefore, some international financial institutions manipulate the interpretation of public welfare (maslahah) and goals (maqasid) to justify their actions and norms (Sabirzyanov and Hashim, 2015). When it comes to mal (wealth), the main goal of Sharia is the legal protection of funds. How funds should be invested is only a secondary goal. However, Islamic banks put profit maximization first. Despite various profitable investments, Islamic banks should prioritize protecting the wealth of depositors instead of investing just to get higher profits. Islamic banks are advised not to engage in normal profit-seeking or maximize their funding sources as financial gains. Some also argue that Islamic banks pay less attention to the overall well-being of society (Khairul Mukminin, 2019). A critical study on the performance of international financial institutions shows a gap between the reality of these institutions and the goals of Islamic economics. Instead of bringing benefits to society, the Islamic banking and finance industry has achieved high profit margins (Sabirzyanov and Hashim, 2015).

From the perspective of Sharia, regarding interests, the rights of Allah must be given supreme status, and human rights will come after all other commitments are fulfilled. In the long run, Islamic banks can protect the value of wealth and other higher values by upholding Sharia, so they should put protection first, followed by establishment and cultivation (Khairul Mukminin, 2018).

Sharia compliance

In the case of Islamic financial transactions, all deals must follow and comply with Islamic law and business transaction rules. Sources of Islamic law include the Quran and Sunnah, along with secondary sources like ijma' and qiyas (Engku Rabiah Adawiah, 2013). The concept of Shariah compliance is often misunderstood as just meeting the minimum legal requirements set by Islamic jurisprudence. Instead, Shariah compliance means growing Islamic finance within the spirit and value system of Islam, and achieving the ideals and goals of Shariah in the financial sector (Laldin and Furqani, 2013a). Maqasid al Shariah is seen as a grand framework that provides guidelines and direction to ensure maslahah (benefit) is achieved and mafsadah (harm) is prevented in all financial contracts (Laldin and Furqani, 2012).

For branch managers, achieving both profit maximization and Shariah compliance is not easy, because in Malaysia, both Islamic and conventional products are offered at the same branch. When this happens, it is clear that there is a mix of lawful and unlawful practices. Although some banks separate the branches that offer Islamic products from those offering conventional ones, it is still questionable whether their daily operations follow Islamic rules. This is not a major issue because the products they offer are Shariah-compliant; it is a micro-level issue. Islamic banks have focused on Shariah-compliant products since they started, rather than products based on Shariah, so the problem is whether daily practices follow Shariah. In other words, do the daily operations of Islamic subsidiaries follow Shariah? In reality, achieving Shariah compliance at a macro level is much harder than at a micro level.

The idea of wealth circulation is a macro goal of Shariah, while the ideas of fair and transparent financial practices relate to the micro goals of Shariah regarding transaction tools and mechanisms. As mentioned before, the role of Islamic banks is to move wealth from the rich (surplus sector) to the poor or those in society who need funds (deficit sector), so that effective wealth circulation can be achieved in society. However, if Islamic banks do not practice what they should and instead act like conventional banks, this goal is hard to reach. If Islamic banks are not much different from conventional banks, the main goal of setting up Islamic banks will remain just a theory.

Islamic Banking: Theory and Reality

In theory, Islamic banking is a subset of the Islamic economic system, aimed at achieving a just, fair, and balanced society, which is written in Sharia (for example, see Ahmed, 1972; Chapra, 1985, 2000; and Siddiqi, 1981). The ban on interest, gambling, and excessive risk is meant to create a fair playing field to protect social interests and promote social harmony (Dusuki and Bouheraoua, 2011).

However, in reality, Islamic banks are a subset of conventional parent banks, and those parent banks are a subset of the capitalist economic system. This conceptual framework was developed based on the arguments presented in the previous sections. This is common in Malaysia and Pakistan, where Islamic banks are often subsidiaries of conventional parent banks. Both the conventional parent bank and the Islamic subsidiary are part (subsets) of the capitalist economy. The CEO, chairman, and board of directors of the conventional parent bank are the parties who may influence the decisions of the CEO, chairman, and board of directors of the Islamic subsidiary. Sharia board members provide advice on Sharia issues and may communicate directly with the boards of Islamic subsidiaries. On the other hand, the Sharia committee may not have direct contact with the general managers and branch managers of Islamic subsidiaries. Because they act as advisors to the boards of Islamic subsidiaries, Sharia board members may not have authority in the decision-making process. Managers may have more power than the Sharia committee during the decision-making process (for example, see Ullah et al. (2016)).

Challenges in implementing Sharia in Islamic banks. The main motivation for choosing Islamic banks is to avoid interest and follow Sharia (Bley and Kuehn, 2004; Haque et al., 2009; Hanif et al., 2012). However, following Sharia has been one of the biggest obstacles for Islamic banks. This section discusses the challenges of implementing Sharia. The main challenges include a lack of understanding among staff and managers of Islamic banks regarding the primary goals of establishing these banks. Customers are willing to pay high prices for products and services that follow Sharia, which helps the high profitability of Islamic banking (Lee and Ullah, 2008, 2011). However, achieving Sharia goals has become one of the biggest challenges for Islamic banks. Ullah (2014) found that Islamic banks in Bangladesh do not follow Sharia well, especially in investment activities, where there are serious Sharia violations. This happens because of a lack of knowledge and seriousness about following Sharia, a lack of proper care in Sharia audits, and a lack of skill and experience among members of Sharia supervisory boards.

Islamic banks face tough competition from traditional banks when creating new products. A simple solution is to rely on a loose interpretation of Sharia, which helps Islamic banks compete faster in profitable markets. The difficult way is to improve management and introduce different products based on profit and loss sharing (PLS) (Warde, 2000, p. 153). The literature shows that many Islamic banks choose the first solution. Because of this, Sharia compliance, which is the pillar of Islamic banking, has to take a backseat.

The main challenges Islamic banks face in following Sharia include: (1) the different goals of Islamic subsidiaries and their traditional parent banks; (2) the goal of Islamic banks to maximize profit; (3) the role of branch managers.

Different goals between Islamic subsidiaries and their parent companies

As Adam Smith proposed in his book The Wealth of Nations, business goals are based on a capitalist economy. Under a capitalist system, individuals are not limited by profit and are allowed to pursue their own interests. Built on Adam Smith's capitalist economy, a company's main goal is to maximize profit and increase market share. In other words, the main goal of a company is to maximize the wealth of the shareholders who contribute to the company and expect to make a profit from their investment. Shareholders appoint managers, who act as agents, to ensure the company's daily operations align with its goals.

The goals of traditional banks align with the economic theory proposed by Friedman (1970). As Friedman (1970) pointed out, company executives or managers are hired by the business owners and have a direct responsibility to those owners, who are their employers. They have a responsibility to run the business to maximize the company's profit while following the basic rules of society, whether required by law or ethics. According to Friedman's (1970) theory, the main goal of a traditional bank's parent company is to maximize shareholder wealth.

On the other hand, the main goal of establishing an Islamic bank is to follow the rules of Sharia, provide benefits to society as a whole (Warde, 2000), and protect the public interest (achieving maslahah). In other words, Islamic banks are built on a religious foundation, and making a profit is only a secondary goal for them. The business side of an Islamic bank works hand-in-hand with religion and the core content of Sharia (Engku Rabiah Adawiah, 2013). Therefore, there are different goals between a traditional parent bank and its Islamic subsidiary.

In an Islamic bank, the goals of the managers and the Sharia board are expected to be the same. In other words, the main goal for both sides is to meet the requirements set out in the Sharia amendment. However, evidence from experience shows this is not the case. For example, in a 2016 study by Ullah and others, these areas were used to check if managers and the Sharia board had the same goals: social welfare, ethical investment, fairness and justice, charity, solidarity, profiteering, secured investment, and traditional mutual benefit. Based on interviews, they found that managers only placed a moderate amount of importance on social welfare, fairness and justice, charity, and solidarity. On the other hand, the Sharia board places high importance on these areas because their main goal is to earn the pleasure of Allah. Regarding profits, managers believe maximizing profit is the main reason for starting an Islamic bank, and they are willing to sacrifice fairness and justice to get high returns. For secured investment, managers prefer financial tools that are convenient, safe, and offer a fixed return. Managers do not like profit-sharing tools like mudarabah and musharakah because these tools are risky and make investment returns uncertain. To compete with traditional banks, managers at Islamic banks choose to offer products similar to those of traditional banks to meet customer needs. Sharia scholars say that managers even ask them to find ways to make all traditional products comply with Sharia. Since managers have more power in decision-making than Sharia scholars, the managers use several pressure tactics to get the scholars to accept the lowest level of Sharia compliance in matters related to Sharia.

For subsidiaries of traditional parent banks, the boards of the Islamic subsidiaries are not independent because they must follow instructions set by the board of the traditional parent bank (see Figure 1). Then, these instructions are passed to the branch managers of the Islamic subsidiary. At the same time, branch managers must follow Sharia rulings passed by Sharia authorities and upheld by the Islamic subsidiary's Sharia board. As mentioned, the parent bank and the Islamic subsidiary have different goals because the former is based on a capitalist economy, which is non-Islamic, while the latter is based on Sharia. To make sure the goals of the parent bank and the Islamic subsidiary align, the Islamic subsidiary only achieves the minimum level of Sharia compliance.

If the parent bank is a conventional bank and the subsidiary is an Islamic bank, how can competition between the two types of banks be achieved when the Islamic bank is just a subsidiary of a conventional parent company? Of course, these subsidiaries do not compete with their parent banks. Instead of competing with or being different from conventional banks, Islamic banks end up imitating the products and practices of conventional banks. This goes against what Dusuki and Abdullah (2014) argued, which is that Islamic banks should compete with conventional banks. Therefore, Islamic banks must realign their goals with the goals of Sharia.

The main challenge for conventional banks transitioning to Islamic banks is the goal of profit maximization while complying with Sharia principles (Shafii, Shahimi, and Said, 2016). Some argue that the operations of Islamic banks are similar to those of conventional banks, except that the former must follow Sharia rulings (Haniff, 2011; 2014). In the current context, Islamic finance tries to gain profitability and efficiency from traditional finance by changing its external structure. Making these changes without altering any substance is not enough, because the goals of the capitalist system are still maintained. For example, current Islamic finance products are modified from traditional counterparts to meet Islamic law requirements (Laldin & Furqani, 2013b, pp. 32-33).

According to Al-Atyat (2007) and Al-Atyat and Hakeem (2010), as cited by Ahmed and Hussainey (2015), the main reason for switching from traditional banking to Islamic banking is to use the profitability of Islamic banks. Many studies prove that Islamic banks are more profitable than traditional banks (for example, see the research by Khediri, Charfeddine, and Youssef (2015), and Ramlan and Adnan (2016)). This also relates to the motivation of managers entering the Islamic banking industry to use the industry's profitability, rather than achieving Sharia goals from the overall business model (Ullah et al., 2016). A study on Islamic banking practices shows that wealth maximization, Sharia rulings (fatwa), the competitive environment, and minimal risk management approaches in the Islamic banking industry push Islamic banks to adopt debt-based financing. Islamic banks defend their practices by adopting Sharia rulings from Sharia scholars to make them comply with Sharia, but they are not based on Sharia. The study concludes that the policies and practices of Islamic banks have deviated from Islamic banking theory and Islamic principles. The focus of Islamic banks has always been on profit maximization rather than social welfare (Ahmed, Akhtar, Ahmed, and Aziz, 2017).

Al-Omar and Iqbal (1999) raised questions about the authenticity of large multinational banks operating in the Islamic banking industry. Their participation in the Islamic banking industry is purely a business activity to use the profitability of Islamic banking operations. Another worrying issue is whether traditional banks strictly follow Sharia regulations and comply with the rules of the Islamic banking industry. Some people think the main factors affecting the shift from traditional banks to Islamic banks are risk and profitability (Al-Alani and Yaacob, 2012).

As previous studies cited by Shafii, Shahimi, and Saaid (2016) show, an environment where Islamic banks operate alongside traditional banks does not fully support Islamic banks in following Sharia principles, because these banks are based on traditional economic systems (for example, see the study by Al-Oqool (2011); Al-Atyat (2007); Al-Martan (2005); Al-Omar & Iqbal (1999); and al-Rabiaa (1989)).

Research in the literature highlights many challenges and obstacles to successfully converting traditional banks to an Islamic banking model. Most studies (for example, Alani & Yaacob, 2012; Al-Oqool, 2011; Al-Atyat, 2007; Al-Martan, 1999) prove that human resources, regulations and legislation, Sharia compliance, and Islamic banking products are the main obstacles affecting the shift of central banking institutions to Islamic banking.

The role of managers

According to Azid, Asutay, and Burki (2007), company managers have two main duties. These are (1) maximizing profit for shareholders and (2) protecting the interests of stakeholders. Stakeholders include not only employees, customers, and suppliers, but also society and the environment. The second role aligns with the goals of Sharia (maqasid), where activities should benefit the entire Ummah, covering human life and well-being. Since Islamic banks often operate as subsidiaries of larger conventional entities, managers are caught between following instructions from top management or the board, and following Sharia rulings passed by the Sharia board, which is a primary requirement for an Islamic entity. In an Islamic subsidiary of a conventional bank, the branch manager is responsible for carrying out instructions set by the board. At the same time, he or she must also follow Sharia rulings passed by the Sharia board. The parent conventional bank aims for profit maximization, which fits a capitalist economic system, while the Islamic subsidiary aims to achieve Sharia goals. This puts the manager in the middle of these two objectives. Because the Islamic bank is just a subsidiary of a conventional parent bank, the goals of both entities must align. Therefore, the goal must be profit maximization.

Another major issue is the background of the managers themselves. Literature widely suggests that managers in Islamic banks lack Sharia knowledge and exposure because they often come from conventional backgrounds. If people who should follow Sharia rules do not clearly understand Sharia principles, then carrying out Sharia rulings will be difficult.

Conclusion and suggestions

The Islamic banking and finance industry started nearly forty years ago. However, many issues remain unsolved today, and new problems keep appearing alongside the growth of Islamic finance. One main reason why issues remain unresolved is that there is no clear distinction between Islamic banks and traditional banks, as both systems coexist in the same economy. Even though Malaysia is known as a center for Islamic banking and finance, there are only two full-fledged Islamic banks; Bank Islam and Bank Muammalat. All other Islamic banks are just Islamic subsidiaries of large conventional banks.

Setting up Islamic subsidiaries for conventional parent banks has caused many unsolved problems. This is likely because the conventional parent banks and their Islamic subsidiaries have different goals. The main goal of a conventional parent bank is to maximize profit for shareholders, while the main goal of an Islamic subsidiary is to follow Sharia rules, with profit being only a secondary goal. Managers who should carry out and follow Sharia rulings still have to follow orders from the top management at the conventional parent bank. The Islamic subsidiary and the traditional parent bank operate out of the same branch. Staff members who work for the traditional parent company also have to handle duties for the Islamic subsidiary. In this situation, conflicts of interest are almost impossible to avoid.

Since most Islamic banks in Malaysia are subsidiaries of traditional banks, and staff often face conflicts of interest between traditional and Islamic banking tasks, the best solution may be to train staff and managers to deeply understand Islamic banking and Islamic teachings. This knowledge helps staff realize why it is important to keep Islamic and traditional banking tasks separate, as there should be a clear distinction between the two.

In short, following Sharia at a minimum level is not enough to truly fulfill Sharia. To reach the goals of Islamic banking, the Islamic spirit of sincerity and honesty should be rooted in the hearts of the managers and staff. If managers and staff have a strong Islamic spirit and always aim for maximum Sharia compliance, then the goals of Islamic banking—such as social justice, poverty relief, and preventing exploitation—can finally be achieved. view all