KembaraXtra – Islamic Banking – Example of Shari’ah-Compliant Payment System (Muqasah / Set-off)​

A Shari’ah-compliant payment system follows the same purpose as a conventional system, which is to settle payments between parties. However, instead of allowing interest-based outstanding balances to arise, Islamic finance uses a mechanism called Muqasah, or set-off, to settle obligations in a fair and Shari’ah-compliant manner.


Muqasah (set-off) means that when two parties owe money to each other at the same time, their debts are cancelled against one another, and only the remaining balance is paid. This method reduces unnecessary payments and completely avoids the charging or payment of interest.


Mandatory Set-off (Muqasah Qahriyyah)

Mandatory set-off occurs automatically and does not require the agreement or consent of either party. It applies when both parties are simultaneously debtors and creditors to one another.


Example:
If Bank A owes Bank B $10,000 and Bank B owes Bank A $7,000, the two debts are set off against each other. The $7,000 is cancelled, and Bank A pays only the remaining balance of $3,000. No interest is charged, and settlement is completed efficiently.


Contractual Set-off (Muqasah Ittifaqiyyah)

Contractual set-off takes place only when both parties mutually agree to cancel their debts against each other. This agreement is made in advance and applies to debts that may arise in the future.


Example:
Bank A and Bank B agree that any future debts between them will be settled through set-off. Later, Bank A owes Bank B $5,000, while Bank B owes Bank A $4,500. By applying the agreed set-off, only $500 is paid by Bank A, and both obligations are extinguished.


Set-off Involving Different Currencies

When debts are denominated in different currencies, Muqasah is still permissible, provided that the conversion is done using the prevailing exchange rate on the actual settlement date. No future or fixed exchange rate is allowed, as this could lead to speculation or unfair advantage.


Example:
If Bank A owes Bank B USD 10,000 and Bank B owes Bank A MYR 40,000, the amounts are converted using the exchange rate on the day of settlement, after which the set-off is applied fairly and transparently.


Why Muqasah Is Important in Shari’ah-Compliant Payment Systems


Muqasah plays a crucial role in Islamic payment systems because it:

• eliminates interest-based settlement balances,
• reduces the number of payment transactions,
• speeds up the settlement process, and
• ensures full compliance with Shari’ah principles.

Exam-Ready Summary

A Shari’ah-compliant payment system settles obligations through Muqasah (set-off), where mutual debts are cancelled against each other and only the net balance is paid, thereby avoiding interest and ensuring fairness and efficiency in payment settlements.

KembaraXtra-Islamic Banking – Linking the Cheque Payment System with Muqasah (Set-off)

The diagram shows the life cycle of a cheque payment in a payment system. In Islamic banking, this same process is used, but the final settlement stage is handled using Muqasah (set-off) to ensure Shari’ah compliance.


Below is how Muqasah fits directly into each part of the payment system.


1. Cheque issuance and deposit (same as conventional)

• The payer issues a cheque to the payee.
• The payee deposits the cheque with their bank (Bank B – collecting bank).

👉 At this stage, there is no difference between conventional and Islamic systems.

2. Clearing through the clearing house

• Bank B sends the cheque to the clearing house.
• The clearing house processes all cheques between banks.
• At the end of clearing, it calculates who owes whom and how much.

👉 This creates interbank debts, for example:

• Bank A owes Bank B
• Bank B owes Bank A

3. Where Muqasah applies (key Islamic difference)

Instead of settling gross amounts, the Islamic payment system applies Muqasah (set-off) at the settlement stage.

• Mutual debts between Bank A and Bank B are cancelled
• Only the net balance remains payable

Example from clearing results:

• Bank A owes Bank B: $10,000
• Bank B owes Bank A: $8,000

👉 Using Muqasah:

• $8,000 is set off
• Bank A pays only $2,000

This avoids:

• outstanding balances
• delayed settlements
• interest (Riba)

4. Settlement through the settlement institution

• The settlement institution (usually the central bank) executes settlement
• Only the net amount after Muqasah is transferred:
  • Bank A is debited
  • Bank B is credited

👉 Settlement is final, efficient, and interest-free

5. Debit and credit advice

• Bank A sends a debit advice to the payer
• Bank B sends a credit advice to the payee

This confirms the transaction is complete.

6. Return exchange (if cheque fails)

• If the cheque is dishonoured (e.g. insufficient funds),
• The item is returned through the payment system,
• Any settlement entry is reversed,
• Muqasah ensures no interest arises during reversal.

Why Muqasah is essential in the payment system

Muqasah ensures that the payment system:

• ✔ settles obligations fairly
• ✔ avoids interest-based balances
• ✔ reduces unnecessary fund transfers
• ✔ complies with AAOIFI Shari’ah standards

Very Simple Summary

In an Islamic payment system, cheque clearing works the same way as a conventional system, but during settlement, Muqasah (set-off) is applied so that mutual interbank debts are cancelled and only the net amount is transferred without interest.


Exam-Ready Answer

Muqasah is applied at the settlement stage of the payment system, where mutual obligations between banks arising from cheque clearing are set off, ensuring final settlement without interest and in compliance with Shari’ah principles.

KembaraXtra-Islamic Banking – Linking the Cheque Payment System with Normal (Non-Muqasah) Settlement

The diagram shows how a cheque payment moves through a conventional payment system. Below is how the same diagram works when Muqasah (set-off) is NOT used, i.e. normal conventional settlement.

1. Cheque issuance and deposit (same start)

• The payer writes a cheque to the payee.
• The payee deposits the cheque with their bank (Bank B – collecting bank).

At this stage, there is no difference between Islamic or conventional systems.

2. Clearing through the clearing house

• Bank B sends the cheque to the clearing house.
• The clearing house processes cheques from many banks.
• It determines gross obligations:
  • how much Bank A owes Bank B
  • how much Bank B owes Bank A

👉 Multiple separate obligations are created.

3. Settlement WITHOUT Muqasah (key difference)

In a normal non-Muqasah system:

• Each bank settles its full obligation
• Debts are not cancelled against each other
• Payments are made separately

Example after clearing:

• Bank A owes Bank B: $10,000
• Bank B owes Bank A: $8,000

What happens (non-Muqasah):

• Bank A pays $10,000
• Bank B pays $8,000

👉 Two payments instead of one net payment.

4. Role of the settlement institution

• The settlement institution (usually the central bank) debits and credits banks’ accounts:
  • Bank A account debited $10,000
  • Bank B account credited $10,000
  • Bank B account debited $8,000
  • Bank A account credited $8,000

If settlement is delayed:

• interest or penalty charges may arise
• temporary outstanding balances may exist

5. Debit and credit advice

• Bank A sends a debit advice to the payer
• Bank B sends a credit advice to the payee

Customers are informed that the transaction has been processed.

6. Return exchange (if cheque fails)

• If the cheque is dishonoured:
  • the item is returned through the system
  • settlement entries are reversed
  • delays may still create interest exposure
  
  

Why this is called “non-Muqasah”

Because:

• debts are not netted off
• gross settlement is used
• interest-based balances may occur
• efficiency is lower compared to set-off

Very Simple Comparison Line

• Non-Muqasah system: pay everything separately
• Muqasah system: cancel debts and pay only the difference

Exam-Ready Linked Answer

In a conventional non-Muqasah payment system, cheque clearing creates gross interbank obligations that are settled separately through the settlement institution, which may result in outstanding balances and interest exposure, unlike Muqasah where debts are netted and only the net amount is settled.

KembaraXtra – Islamic Banking – Mixing Conventional and Shari’ah-Compliant Payment and Settlement Systems


In countries that operate a dual-banking system (where Islamic and conventional banking coexist), a common question arises:
Do Islamic Financial Institutions (IFIs) need a separate payment and settlement system from conventional banks?

General Shari’ah position
From a Shari’ah perspective, there is no requirement to separate Islamic and conventional payment or settlement systems. This is because the main function of a payment system is purely operational:

• to transfer money from the payer, and
• to credit the rightful recipient.

The source of the funds—whether they originate from Islamic or conventional banking activities—does not affect the validity of the payment system itself. What matters is that the transfer is accurate, timely, and final.

What must be segregated

Although the payment infrastructure can be shared, Islamic banks operating:

• in a dual-banking environment, or
• through Islamic “windows” within conventional banks

must maintain internal segregation. This means:

• Islamic transactions must be recorded separately,
• Islamic funds must not be mixed with conventional funds internally, and
• reporting systems must clearly distinguish Islamic and non-Islamic activities.

Example: Malaysia’s dual-banking system

Malaysia provides a practical example of how conventional and Islamic payment systems can operate together.


Islamic banks and conventional banks offering Islamic windows are required to maintain a Wadiah (safe-keeping) current account with Bank Negara Malaysia (BNM). This account is used to facilitate cheque-clearing and settlement activities.


Under the principle of Al-Wakalah (agency), banks authorise BNM to manage their settlement positions during the automated cheque-clearing process.


How deficits are handled (step by step)

1. During cheque clearing, a bank may end the day with a settlement deficit.
2. BNM provides temporary funding using a Shari’ah-compliant, repo-like arrangement.
3. The bank sells Islamic securities or papers (previously deposited with BNM) to BNM.
4. BNM provides cash proceeds to cover the settlement shortfall.
5. The bank later repurchases the same securities from BNM at an agreed price.
6. The securities are redeposited with BNM.
7. This process is repeated whenever a deficit arises.

This mechanism achieves the same liquidity management objective as a conventional repo, but without interest, ensuring Shari’ah compliance.

Why this approach works

• ✔ One national payment system is maintained (efficient and cost-effective)
• ✔ Islamic and conventional banks can coexist smoothly
• ✔ Internal Shari’ah compliance is preserved
• ✔ Interest (Riba) is avoided
• ✔ Central bank liquidity support remains effective

Very simple summary

Islamic banks do not need a separate payment system. They can use the same national payment and settlement infrastructure as conventional banks, provided Islamic transactions are internally segregated and liquidity support is structured using Shari’ah-compliant mechanisms.



In a dual-banking system, Shari’ah does not require separate payment and settlement systems for Islamic and conventional banking. What is required is internal segregation of Islamic transactions and the use of Shari’ah-compliant liquidity arrangements, such as agency-based and Islamic repo-like facilities, as practiced in Malaysia.

KembaraXtra – Islamic Banking – Cheque Payment Systems and Insufficient Client Funds​

In a Shari’ah-compliant cheque payment system, a special issue arises when a customer (the payer) does not have enough money in their account to cover a cheque they have issued.

What happens when funds are insufficient?

When an Islamic bank receives a cheque for payment and finds that the payer’s account has insufficient funds, the bank has two Shari’ah-compliant options:


Option 1: Dishonour the cheque

• The bank may reject or dishonour the cheque.
• The payment is not made to the payee.
• This is similar to conventional banking practice and is fully acceptable under Shari’ah.

Option 2: Honour the cheque using a short-term facility

Alternatively, the Islamic bank may decide to honour the cheque in order to help the customer and maintain payment system stability.

• The bank extends a short-term interest-free facility to the payer.
• This facility is usually structured as a Qard Hasan (benevolent loan).
• The bank temporarily pays the cheque on behalf of the customer.
• The customer is required to repay only the principal amount.

Fees and charges (important Shari’ah rule)

The type of contract used determines what the bank is allowed to charge:

• Under a Qard Hasan contract:
  • ❌ No interest or profit can be charged.
  • ❌ No penalty for the use of money.
  • ✅ The bank may charge only an administration fee.
  • This fee must reflect actual costs incurred (e.g. processing and operational expenses).

👉 The fee cannot be linked to time, amount, or profit, as this would resemble interest (Riba).


Why this approach is Shari’ah-compliant

This arrangement:

• avoids interest (Riba),
• prevents unjust enrichment,
• supports smooth operation of the payment system,
• balances customer support with Shari’ah ethics.

Very simple summary

If a cheque is presented with insufficient funds, an Islamic bank may either dishonour it or honour it by giving the customer a short-term, interest-free loan (Qard Hasan), charging only actual administrative costs.


In a Shari’ah-compliant cheque payment system, when a customer has insufficient funds, the bank may dishonour the cheque or honour it by providing a short-term Qard Hasan facility, under which no interest is charged and only actual administrative expenses may be recovered.

KembaraXtra – Islamic Banking – Regulation and Governance of the Islamic Financial Services Industry (IFSI)


Regulation and governance in the Islamic Financial Services Industry (IFSI) are designed to ensure that the financial system remains sound, stable, and trustworthy. This is achieved through effective supervision, transparency, disclosure, and market discipline. Financial laws and licensing requirements determine how different financial institutions are structured and how they are allowed to operate. Together, regulatory rules, supervisory processes, and reporting standards help to protect the financial interests of stakeholders and maintain confidence in the system.


In the banking sector, a key regulatory objective is the protection of depositors and the safeguarding of investment account holders. This is particularly important in Islamic banking because investment accounts are based on profit-and-loss sharing rather than guaranteed returns. As a result, regulators have had to introduce additional governance measures to address the unique risks faced by investment account holders and to ensure fairness, proper disclosure, and accountability by Islamic banks.


In the Islamic capital market, regulation focuses on protecting investors who are concerned with:

• the performance of Islamic funds and instruments,
• market liquidity, and
• compliance with Shari’ah principles.

The issuance of new Shari’ah-compliant instruments and the continuous screening of stocks for Shari’ah compliance have led to additional governance requirements, including enhanced disclosures, Shari’ah certification, and ongoing monitoring by Shari’ah boards and regulators.


At the national level, the policies set by financial authorities and governments play a major role in shaping the size, depth, and sophistication of the Islamic financial industry. The volume of issuance and trading of Islamic financial instruments reflects the level of market acceptance, investor confidence, and liquidity. A wide range of Islamic products and instruments also allows investors to choose investments that match their risk appetite and financial preferences, thereby supporting effective financial intermediation.


Monetary policies—such as reserve requirements, open market operations, and financing rate policies—also influence the supply of funds in the Islamic financial system. Whether these policies are rigid or flexible affects liquidity conditions and overall market activity. Regulation therefore plays a crucial role in ensuring that Islamic financial systems remain flexible enough to accommodate innovation, while still maintaining strong oversight, risk management, and reporting standards.


Overall, effective regulation and governance provide investors with greater choice, ensure continuous monitoring of financial institutions, and promote systemic stability. These improvements in the regulatory and governance framework have been a key factor behind the rapid and sustained growth of Islamic banking and Islamic capital markets worldwide.
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Exam-Ready Summary

Regulation and governance of the IFSI aim to ensure financial stability, protect depositors and investors, promote transparency and Shari’ah compliance, and support sustainable growth through effective supervision and sound monetary and institutional policies.

KembaraXtra – Islamic Banking – Country-Specific Regulations

Overview
Regulatory environments of financial systems differ across countries, but they tend to converge when international governing and standard-setting bodies issue common standards and guidelines. These standards promote best practices and facilitate cross-border financial flows. The Islamic Financial Services Industry (IFSI) faces similar challenges because countries adopt different regulatory approaches to Islamic finance based on their economic, social, legal, and cultural circumstances.


Variation Across Jurisdictions
Laws, regulations, and supervisory frameworks vary significantly across jurisdictions. This variation largely arises from whether a country adopts a single Islamic financial system or a dual system that accommodates both conventional and Islamic financial services. Such policy decisions have important implications for competition, growth, and long-term sustainability of the industry.


Single Islamic Financial System
In a single system, all financial institutions operate exclusively in accordance with Islamic principles. The growth and sustainability of this system depend heavily on consistent government policy support. Any lack of regulatory commitment or policy inconsistency may negatively affect the development and stability of the Islamic finance industry.


Dual Financial System
Under a dual system, Islamic and conventional financial services operate in parallel. Governments adopting this model recognise the need to support both systems while maintaining overall financial stability. The regulatory challenge lies in ensuring fair competition, balanced growth, and systemic stability within and across both industries.


Licensing Models and Institutional Structures
The dual system has led to the emergence of different forms of Islamic Financial Institutions (IFIs). Initially, only fully fledged Islamic banks were permitted. Subsequently, Islamic windows within conventional banks were introduced to encourage participation. As demand for more advanced services increased, Islamic banking subsidiaries of conventional banks were established. Early Islamic banking models adapted conventional lending structures into Shari’ah-compliant financing, which later evolved into trading- and investment-based models emphasising risk sharing and partnership.


Legislative and Supervisory Challenges
Dual systems raise regulatory questions regarding whether Islamic finance should be governed under a single legal framework or through separate legislation under the same financial authority. Some countries have enacted specific laws for Islamic finance, while others regulate Islamic activities within existing financial laws. In most cases, however, monetary policy instruments apply uniformly to both systems.


Malaysia’s Regulatory Leadership
Malaysia has played a pioneering role in developing Islamic finance regulation and governance. It enacted the Islamic Banking Act in 1983 to formally establish Islamic banking and amended tax laws to prevent double taxation arising from Islamic financial transactions. Malaysia also formalised the dual banking system through amendments to its banking legislation and strengthened Shari’ah governance by establishing a centralised Shari’ah Advisory Council under the central bank.


Governance, Tax Neutrality, and Capital Markets
Through comprehensive legislation, regulation, and supervision, Malaysian authorities ensure that IFIs maintain effective governance structures, including boards of directors, audit committees, and Shari’ah boards. Tax neutrality policies have been introduced to ensure Islamic products remain competitive with conventional products. Similar regulatory progress has been achieved in Islamic capital markets through guidelines on Islamic securities, Islamic unit trusts, and Islamic real estate investment trusts.


Conclusion
Country-specific regulations continue to shape the development of Islamic finance. While international standards encourage convergence, national legal and regulatory frameworks remain decisive in determining the growth, stability, and governance quality of the IFSI. Malaysia’s experience illustrates how proactive regulation and governance can support sustainable development of Islamic finance.
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Kembaraxtra-Islamic Banking – Regulatory Framework in Bahrain

Overview
Bahrain has developed one of the most comprehensive and progressive regulatory frameworks for the Islamic Financial Services Industry (IFSI). Its regulatory model is characterised by a single regulator, a dual-banking system, and early adoption of international Islamic finance standards, which together have positioned Bahrain as a global hub for Islamic finance.


The Bahrain Monetary Agency (BMA)
The regulatory framework in Bahrain began with the establishment of the Bahrain Monetary Agency in 1973 under Amiri Decree No. 23 (1973). The BMA was mandated to act as the central bank and regulator of the banking system. Its responsibilities included implementing monetary policy, supervising and regulating banks, acting as the government’s fiscal agent, and managing the Kingdom’s foreign currency reserves. From 1975 onwards, the BMA was also tasked with developing Bahrain into a major international financial centre.


Expansion of Regulatory Mandate
In 2002, the BMA’s mandate was significantly expanded, making it the single regulator for all financial institutions in Bahrain. This expansion brought the supervision and regulation of the insurance sector and capital markets under the BMA’s authority, creating a more integrated and coherent regulatory structure.


Regulatory Reforms and Licensing Framework
On 28 June 2006, the BMA announced a comprehensive package of regulatory reforms aimed at modernising and strengthening the financial sector. These reforms, which came into effect on 1 July 2006, introduced a new activity-based licensing framework. Under this framework, licences are issued based on regulated activities rather than institutional type, allowing greater flexibility and responsiveness to market developments. The five main licence categories are: conventional banking, Islamic banking, insurance, investment business, and specialised licensees.


A key feature of the reforms was the simplification of onshore and offshore banking categories. Offshore banks were allowed to conduct onshore business under controlled conditions. The former “full commercial bank” licence was replaced with a “retail bank” licence, while the two offshore sub-categories were merged into a single “wholesale bank” licence.


Wholesale Banking Framework
Under the revised framework, wholesale banks are permitted to undertake individual onshore transactions above BD7 million (approximately US$18.62 million) for deposit-taking and credit provision, and above US$250,000 for investment business transactions, including the sale of investment products. This flexibility enhanced Bahrain’s competitiveness as a regional and international financial centre.


Transition to the Central Bank of Bahrain (CBB)
On 7 September 2006, the BMA was formally transformed into the Central Bank of Bahrain under the Central Bank of Bahrain and Financial Institutions Law 2006. The CBB retained all central banking responsibilities, including implementing monetary and foreign exchange policies, managing government reserves and debt issuance, issuing the national currency, and overseeing payment and settlement systems. Importantly, the CBB became the sole regulator of Bahrain’s entire financial sector, covering banking, insurance, investment business, and capital markets.


Role in Islamic Finance Regulation
As a single regulator overseeing both conventional and Islamic financial services, the CBB has ensured strong regulatory consistency and effectiveness. With the rapid growth of Islamic finance, the CBB has increasingly focused on supporting the dynamism and globalisation of the IFSI. Bahrain’s policy of allowing offshore banks to conduct onshore operations has given it a first-mover advantage in internationalising Islamic finance within a dual system governed by a single legislative framework.


Leadership in Shari’ah-Compliant Regulation
The CBB has introduced several pioneering regulatory initiatives. It was the first central bank globally to issue prudential regulations specifically for Islamic banks through the Prudential Information and Regulations for Islamic Banks (PIRI). Uniquely, the CBB has publicly committed to aligning its regulations with the standards issued by the Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI), reinforcing international confidence in Bahrain’s Islamic finance framework.


In addition, Bahrain introduced a trust law in August 2006, providing a strong legal foundation for trust structures. This development is particularly important for Sukuk issuance, as Sukuk structures are typically based on trust arrangements to protect investors’ interests.


Conclusion
Bahrain’s regulatory framework is distinguished by integrated supervision, activity-based licensing, and early adoption of Islamic finance standards. Through the evolution from the BMA to the CBB, Bahrain has consolidated its position as a leading jurisdiction for Islamic finance, offering a stable, transparent, and globally aligned regulatory environment.


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