Chapter 1 Islamic Finance and Banking
Introduction: Islam as a comprehensive system provides guidelines for human behaviour
throughout life. It does that through a set of beliefs. These beliefs organise the relationship between
the individual and Allah, the individual and other human beings, as well as the individual and the
environment.
Economics is one of the most important aspects of human life. Economic behaviour, as expressed
in terms of economic activities involves the production, distribution and consumption of goods
and services. As a part of its guidance, Islam renders clear guidelines towards the economic
behaviour of human beings. Let us begin with the subject of Islamic Economics. The principles
and fundamentals of Islamic Economics are derived from two primary sources, i.e., the
Quran and the Sunnah
Islamic economics is the knowledge and application of injunctions and rules of the Shariah
(Islamic law) that prevent injustice in the acquisition and disposal of material resources in order to
provide satisfaction to human beings and enable them to perform their obligations to Allah and the
society.
In the Quran Allah says:
“But seek, with that (wealth) which Allah has bestowed on you, the home of the Hereafter, and
forget not your portion of lawful enjoyment in this world; and do good as Allah has been good to
you, and seek not mischief in the land. Verily, Allah likes not the Mufsideen (those who commit
crimes and sins, oppressors, tyrants, mischief-makers, corrupters)”-(Al Quran 28:77).
Principles of Islamic economics that are derived from the Quran
and Sunnah:
1.
Real owner: The first principle of Islamic economics is that of ownership or that of the
real owner. It is clearly mentioned in the Quran that Allah has created all the wealth
available on the earth and in the heavens. Hence, He is the real owner of this world
with all its resources, wealth and factors of production.
In the Quran Allah says:
“To Allah belongs all that is in the heavens and all that is on the earth”-(Al Quran 02:284).
The individual and collective ownership of human beings in the resources and wealth is recognized
in a sense that one should acquire the resources with one’s personal efforts and utilise them, thus
adding and deriving utility through economic activities.
Every human being has an equal right to utilise the natural resources created by Allah. It is not
permitted to hold the property or resources unused or barren for a reasonably longer period. The
Quran states that if some property or wealth is left behind after an individual’s demise, then it has
to be distributed to others through the Quranic ‘law of inheritance’.
In the Quran Allah says:
“There is a share for men and a share for women from what is left by parents and those nearest
related, whether the property be small or large - a legal share...” (Al Quran 04:07-12).
ii. Man and His position: Islam charts the actual position to man. Allah states in the Quran
that He has sent man as His vicegerent or Khalifa on earth.
In the Quran Allah says:
”Verily, I am going to place (mankind) generations after generations on earth”-(Al Qur’an 02:30).
Human beings have been created in the best stature.
In the Quran Allah says:
“Verily, We created man in the best stature (mould)”-(Al Quran 95:04).
They have an in-built ability to discern and choose between good and evil. They have rights and
duties. They should fulfill both the rights of Allah and the rights of Allah’s creations. Humans
should follow the guidelines sent down by Allah in the form of divine books for they are
accountable for all their deeds. On the basis of their actions, whether good or evil, they would
either be rewarded or punished. Choosing and following the right path, i.e., the path of Islam, i.e.,
submission to the will and laws of the Creator, would be the determinant in this reward or
punishment
iii. Wealth and resources: Allah has created abundant wealth and resources, both actual and
potential that support man’s existence on this earth.
In Islam, a part of the surplus earned (in a specific time period) by individuals due to Allah’s mercy
or due to ability and favourable conditions bestowed by Allah Himself, must go to their fellow
beings as their share.
In the Quran Allah says:
“And indeed We have honoured the Children of Adam, and We have carried them on land and sea,
and have provided them with At-Tayyibat (lawful good things), and have preferred them above
many of those whom We have created with a marked preferment”-(Al Quran 17:70).
The resources that directly support man’s existence are known as actual resources and the
resources that are useful for humans after adding the utility in terms of economic benefits
are known as potential resources. Every human being is encouraged to work hard to acquire,
earn, harness and utilise those resources but only in the way prescribed by Allah. While earning
and harnessing the wealth, one must, for example, not forget that wealth is created for human
beings and human beings are not created for wealth; they are travellers. Allah has clearly
differentiated between what is permissible and what is prohibited. Every human being has the right
to earn and acquire as much wealth as possible, but within the permissible boundaries set by Allah,
without transgression to Allah or to any human or non-human creation.
iv. Economic trust and relationship: Allah has distributed all the resources and wealth
unequally on the earth.
In the Quran Allah says:
“It is We Who portion out between them their livelihood in this world, and We raised some of
them above others in ranks, so that some may employ others in their work”-(Al Quran 43:32).
Due to this diversity, we do not find two landscapes equally fertile or equally favourable for
production, and two individuals equally able to struggle or equally efficient to work and equally
intelligent to utilise the opportunity. Hence, it is possible for one individual to acquire more wealth
than the other. Therefore, in Islam, a part of the surplus earned (in a specific time period) by
individuals due to Allah’s mercy or due to ability and favourable conditions bestowed by
Allah Himself, must go to their fellow beings as their share.
In the Quran Allah says:
”They ask you (O Muhammad) what they should spend. Say: Whatever you spend of good must
be for parents and kindred and orphans and Al-Masakin (the poor) and the wayfarer, and whatever
you do of good deeds, truly, Allah knows it well”-(Al Quran 02:215).
v. Economic activities: The economic activities include the production, distribution and
consumption. First, there should not be exploitation of the weak and the poor in the activity of
production.
In a Hadith the Prophet Muhammad (Peace be upon Him) said: “The wages of a labourer
must be paid to them before the sweat dries upon their body”-(Ibn Majah, No: 2434).
One cannot produce the goods and services that are prohibited in Islam and are harmful to the
society. The commodities and services to be produced are categorized into necessities, comforts
and luxuries. The first preference in the production process shall be given to necessities, then
comforts and then followed by luxuries.
vi. Trade and business: Allah has permitted the trade. In the Quran Allah says:
“...they say: “Trading is only like Riba (usury),” whereas Allah has permitted trading and
forbidden Riba (usury)...”(Al Quran 02:275).
The Prophet Muhammad (Peace be upon Him) too preferred trade and always encouraged
business.
In a Hadith the Prophet Muhammad (Peace be upon Him) said: “A truthful businessman will be
under the shade of the throne of Allah Ta’ala on the Day of Resurrection”-(AlIsbihani). In another
Hadith the Prophet Muhammad (Peace be upon Him) said: “The truthful merchant [is rewarded by
being ranked] on the Day of Resurrection with prophets, veracious souls, martyrs and pious
people”-(Tirmidhi, No: 1130).
vii. Role and nature of money: Islam views ‘money’ as only a medium of exchange and a
measure of value. The rationale behind this principle is that, every human being needs a large
number of commodities for survival. The transaction of exchange is inevitable among people who
have the commodities and those who need such commodities. But there must be a measure on the
basis of which price can be determined, because the exchanged commodities are neither of the
same type, nor of the same measure which can determine how much quantity of one commodity
is a just price for another. Therefore, all these commodities need a medium to measure their exact
value. Hence, ‘money’ is invented as the medium to measure all the commodities, services, assets
or wealth as a whole.
viii. Debt in Islam: Debt is generally discouraged in Islam except under conditions where it
becomes a necessity. And people engaging in debt based transactions should ensure they have the
potential ability or capability to repay in accordance with the terms and conditions of the debt
arrangement. In the Quran Allah says:
“O you who believe! When you contract a debt for a fixed period, write it down....”-(Al Quran
02:282).
In a Hadith the Prophet Muhammad (Peace be upon Him) prayed: “O Allah, I seek refuge with
You from sin and heavy debt”-(Dua). The Prophet Muhammad (Peace be upon Him) on many
occasions has warned about the punishment for not repaying the debt. Once he is reported to have
offered obsequies or the funeral prayer for a deceased person who had an unsettled debt, only after
the debt was settled. Here is a Hadith for reference: “The Prophet (Peace be upon Him) refrained
from offering the funeral prayer for one who had died owing two dinars, until Abu Qataadah (may
Allah be pleased with him) promised to pay it off for him. When he saw him the following day
and said, I have paid it off, the Prophet (peace and blessings of Allah be upon Him) said: “Now
his skin has become cool for him”-(Musnad Ahmad (3/629).
ix. Zakat and charity: The act of giving Zakat is purifying one’s wealth to gain Allah’s
blessing to make it grow in goodness. As discussed earlier, Islam encourages every individual to
earn and acquire as much wealth as they can in a righteous way. There is no restriction on the
amount or value of wealth one can own. But, the basic principle is that from the surplus of the
wealth one owns, there is need to spend a portion or part in the way of Allah for the benefit of the
individuals in the society who are in need.
In the Quran Allah says:
“Believe in Allah and His Messenger (Muhammad), and spend of that whereof He has made you
trustees. And such of you as believe and spend (in Allah’s Way), theirs will be a great reward...”(Al Quran 57:07).
This principle is derived from the fact that all wealth belongs to Allah, and people are only
trustees for Allah’s wealth. It is Allah’s invisible hand that turns the wheel of economic life.
Hence, Allah has made it obligatory that a small portion (2.5 percent) of the surplus wealth He
entrusted to individuals to be paid annually in the form of Zakat as a way of purification of one’s
wealth, and as the share of the poor and the needy and those who are eligible to receive it.
In the Quran Allah says:
”And perform As-Salat (Iqamat-as-Salat), and give Zakat....”(Al Quran 02:110).
x. Savings in Islam: In the Quran Allah says:
[(Yusuf (Joseph)] said: “For seven consecutive years, you shall sow as usual and that (the harvest)
which you reap you shall leave it in the ears, (all) except a little of it which you may eat.”Then
will come after that, seven hard (years), which will devour what you have laid by in advance for
them, (all) except a little of that which you have guarded (stored). “Then thereafter will come a
year in which people will have abundant rain and in which they will press (wine and oil)”-(Al
Quran 12: 47-49).
We also find Ahadith where the Prophet Muhammad (PBUH) advised not to leave one’s children
begging or poor behind after one’s death.
Here is a Hadith for reference: “Sa`d b. Abi Waqqas, who wanted to make out a will giving away
in charity everything that he owned: He went to the Prophet (Peace be upon Him) and said to him:
“O Messenger of Allah! I have a lot of wealth and only my daughter to inherit it from me. Should
I bequeath all of my wealth in charity?” The Prophet ((Peace be upon Him) told him that he should
not do so. Then Sa`d suggested bequeathing two-thirds of his wealth to charity. When the prophet
again refused, Sa`d then suggested half of his wealth. At this point the Prophet (Peace be upon
Him) replied: “One-third, and that is still too much. It is better for you to leave your heirs wealthy,
rather than leaving them dependent and begging from others”-(Sunan al-Tirmidhi (2042), Sunan
Abi Dawud (2480), Sunan al-Nasai (3567) and Sunan Ibn Majah (2699)].
xi. Reward in Islam: Islam states that self-satisfaction, profit, and self-development do
matter, but not to the extent that Islam accords to the life hereafter. There is much beyond these
materialistic rewards, in the form of heaven and true success in the eternal life.
In the Quran Allah says:
“And whatever you spend in good, it will be repaid to you in full, and you shall not be wronged....”(Al Quran 02:272).
In fact, by following the divine principles in acquisition, utilisation and distribution of wealth, both
the individual and the society enjoy the fruits of prosperity, development and success in the life
here and that of here after.
Why study islamic finance?
The emergence of islamic finance as a new discipline within the long-established and deep-rooted
conventional finance for the past four decades is of particular significance to muslims whose lives
are governed by the rules and values, prescribed by islamic law and principles i.e. shari’ah. It is
estimated that there are over 550 financial institutions with $1 trillion assets adhering to islamic
finance principles, operating in 75 countries encompassing most of the muslim world. Islamic
finance is built upon some distinctive and uniques characteristics which are based upon certain
principles underlined by shari’ah emphasising on the prohibition of riba, prevention of gharar,
prohibition of maysir, prohibition of ethically and socially unacceptable businesses,
prohibition of monopoly, introduction of zakat and co-operation for the benefit of society
and development of all halal aspects of business, trade and investment. By studying islamic
finance we want to:
i.
ii.
iii.
iv.
v.
understand the importance of religion and economic factors in Islamic
finance and banking.
define the concepts underlying Islamic finance and banking.
define the concept of unpleasant practices and identify its components.
discuss the legal maxims and main underlying Islamic principles related to
Islamic financing instruments which are Shariah compliant.
identify the structure of a modern Islamic financial system.
Shariah is the bedrock of the Islamic financial system
The emergence and rapid growth of islamic finance today is a reflection of the
comprehensiveness and completeness of islam as a religion and way of life. It is
really represented as an integrated and holistic worldview covering various aspects
of human living, economic activity, political behaviour and educational
development. Ibadah of muslims relates strictly to the pillars and muamalah of islam.
The development of islamic financial system over the past few decades is a clear
manifestation of the islamic worldview which is represented by shari’ah that is the
bedrock of the worldview of islam.
What exactly is shariah?
Sharia or sharia law (Arabic: ‫ )شريعة‬is the Islamic legal system derived from the religious precepts
of Islam, particularly the Quran and the Hadith. The term sharia comes from the Arabic language
term sharī ah, which means a body of moral and religious law derived from religious prophecy,
as opposed to human legislation. Sharia deals with many topics, including crime, politics, and
economics, as well as personal matters such as, hygiene, diet, prayer, everyday etiquette and
fasting. Adherence to sharia has served as one of the distinguishing characteristics of the Muslim
faith historically. In its strictest and most historically coherent definition, sharia is considered in
Islam as the infallible law of God. There are two primary sources of sharia: the Quran, and the
Hadiths (opinions and life example of Muhammad).
◼ When applied to finance, much of these laws, rules and interpretations of the shari’ah take
into consideration issues of social justice, equity and fairness, as well as the particularly of
commercial transactions. Islamic financial institutions must ensure that all their
transactions are shari’ah compliant, not only in their forms and legal technicalities, but
more importantly in their economic substance, which should be premised on the objectives
outlined by the shari’ah also known as maqasid al-shari’ah.
Value proposition of the Islamic financial system
Islamic finance falls within the scope of islam as religion under which muslims are obliged to
uphold the utmost sincerety, justice and moral values when dealing with other human beings.
Islamic economic system is based on the following philosophical foundations:
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Tawhid-God’s unity & sovereignty
Rububiyyah-divine arrangements of things perfectly
Risalah-prophethood and guidance
Akhirah-belief in accountability on the day of judgement
Istikhlaf-man’s role as God’s vicegerent on earth
Tazkiyah- purification and growth
Kafalah-social solidarity
Adalah-justice
Falah-success in this world and hereafter
Reasons for Riba Prohibition
1.
2.
3.
4.
5.
Riba corrupts society (Surah ar-Rum 37-41)
Riba implies improper appropriation of others’ property (Surah an-Nisa 160-161)
Riba’s ultimate effect is negative growth (Surah al-Baqarah 276)
Riba demeans and diminishes human personality (Surah al-Baqarah 275)
Riba is unjust (Surah al-Baqarah 279)
Functions Islamic financial system
Prohibiting the receipt and payment of interest is the nucleus of the system, it is supported by other
principles of Islamic teachings advocating individuals' rights and duties, property rights, equitable
distribution of wealth, risk-sharing, fulfilment of obligations and the sanctity of contracts.
Similarly, the Islamic financial system is not limited to banking rather involves with the
followings:
1. Bringing together surplus fund units to deficit fund units through shari’ah –
compliant manner.
2. Channeling of investable funds from surplus-income units to deficit income
units.
3. Mobilizing large amounts of relatively small savings and pool them together
to channel them for productive investments in the economy.
Types of Islamic financial markets
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Debt (sukuk i.e. PLS) vs equity markets
Money vs capital market (Islamic money market-government investment issue, islamic
treasury bills, islamic negotiable instruments)
Primary vs secondary markets
Organized exchange vs over-the-counter markets.
Islamic financial intermediaries
Islam fully recognizes the useful role that financial intermediation can play value. Historically, the
role of a financial intermediary in the Islamic economy is found in the principle of al-muḍārib
udārib; a practice which has existed in Islamic history since early centuries. It can be
expressed as, “the one who mobilizes funds, on profit-sharing basis, can extend these
funds to the users on the same basis”. Similarly, in leasing, the lessee who possesses the
usufruct, may sell these against a higher price (rent), and create additional value. In the early
Islamic period, most caravan trades were financed by muḍārabah (trust financing) and money
transfer was quite common among businessmen. Islamic scholars consider the earning of profits
from an intermediary role as a genuine occupation. It is however, noticeable that such financial
intermediation is interwoven with the production and exchange of real goods and services
Types of Islamic financial intermediaries
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Islamic commercial banks
Savings and loan associations
Mutual savings banks
Credit unions
Contractual savings institutions-Islamic insurance companies and pension funds
Investment intermediaries- finance companies and mutual funds
Requisites of Islamic financial system
The islamic financial system, being an integral part of an overall islamic economic system, requires
a conducive environment that not only conforms to the rules and principles of shari’ah but at the
same time, enables it to work effectively and efficiently. The followings are some essential
requirements for a successful islamic financial system:
1.
2.
3.
4.
5.
Strong risk management practice
Effective regulation
Sound corporate and shari’ah governance
A supportive legal framework
Robust accounting disclosure and taxation regime.
Principles and development of Islamic finance
1. Prohibition of Interest (RIBA)
“An excess” Any unjustifiable increase of capital whether are loans or sales in the central tenant
of the system.
Islamic regulations encourage the earning of profit but forbid the charging of interest.
2 Money as a potential capital
It joins hands with other resources to undertake a productive activity.
3. Risk sharing
When interest is prohibited, suppliers of fund become investors instead of creditors.
Investors & financial intermediary relationship is based on profit & loss sharing principles.
4. Prohibition of speculative behavior
Discouraging hoarding & prohibits transacting featuring extreme uncertainties.
5. Sanctity of contracts
Upholding contractual obligations & the disclosure as a sacred duty to reduce the risk of
asymmetric information & moral hazard.
6. Sharing-approved activities
Only activities that don’t violate the rules of shariah qualify for investment.
Any business Dealing with alcohol, gambling or casinos is prohibited.
7. Social justice
In Principle, any transaction leads to injustice & exploitation is prohibited.
Development and growth of Islamic finance
1) Development of Islamic finance
• A rapidly growth part of the financial sector in the world ( >15% annual growth rate).
• Not only Islamic countries, more than 550 financial institutions in over 75 countries
practice some form of Islamic finance.
• The market current turnover is estimated to be $350 Billion compared with $5 Million
in 1985.
• Islamic finance industry has reached $1.4 Trillion by the end of 2011, expected to be
$4 Trillion over medium term.
• Global conventional banks (HSBC, Citibank…etc.) have setups separate windows to
offer Islamic banking services.
2) Emergence & evolution of Islamic institutions in recent history
▪
In Muslim countries:
o 1963, local saving banks was established in Egypt to practice their
work on a none-interest bases to enhance the banking habit.
o After 1974, many Islamic banks were established in different
Muslim countries due to the sharp increase of the oil prices.
o Sudan, Iran, Pakistan started the Islamization of banking system
during 1980s.
▪
In the western world:
o In 1983 Islamic finance house started in Luxemburg.
o
recently, besides establishing Islamic banks, Islamic windows in
leading banks pursuing this market very aggressively.
Basic contracts & instruments
1. Financing instruments
Used to finance obligations arising from the trade and sale of commodities or property and
collateralized by the product being financed, such as:
a) Murabahah
▪
A bank purchases a product for a customer who doesn’t have a
capital. Both agree on a profit margin added to the cost, the customer
should pay the bank later the whole amount.
b) Bay Al-Muajjil
▪
A sale transaction with deferred payment allows the sale of a product
on the bases of deferred payment.
c) Bay Al-Salam (prepayment for products)
▪
The buyers pays the seller the full price of a product which the seller
promises to deliver at a specific future date.
d) Ijarah
•
A medium term financial instrument gives something in return for
rent, resembles the leasing contract.
e) Istisnah
▪
To facilitate the manufacture of an asset at the request of the buyer.
Once the manufacturer undertakes to manufacture the asset for the
buyer, the transaction of Istisnah comes into existence.
2. Investing instruments
b) Vehicles for capital instrument in the form of a partnership.
c) Mudarabah
▪
A fund management instrument , could be short, medium or long
term, whereby an investor entrust capital to an agent to undertake a
project.
d) Musharakah
▪
An equity partnership instrument which could be either medium or
long term partnership, where two or more persons combine either
their capital or their labor to share the profit & losses.
Islamic financial institutions in practice
Early forms of Islamic financial institutions were concentrated in commercial banking activities,
todays’ Islamic financial institutions can be divided into the following broad categories
•
Islamic banks
✓ Could be public or private sector.
✓ A hybrid of conventional commercial banks & investment banks, it
resembles universal banks.
•
Islamic windows
A setup in a conventional bank that offer Shariah-compliant product.
3) Islamic investment banks & funds
✓ Aiming to capitalize on large investment syndications, market-making and
under writing opportunities.
✓ Succeeded in developing
infrastructure finance.
innovative
large-scale
transactions
in
4) Islamic mortgage companies
✓ Targeted at the housing market for Muslim communities in western
countries.
✓ Four models:
▪
Ijarah.
▪
Equity partnership (diminishing Musharaka).
▪
Murabahah (sales transaction).
▪
Lines of corporative societies.
5) Islamic insurance companies (Takaful)
▪
Takaful means mutual or joint guarantee. The participants agree to share
their losses by contributing periodic premiums in the form of investment.
They have to redeem the residual value of profits after fulfilling the claims
and premiums, which is a critical difference between contemporary
insurance and Takaful. Takaful is a given solidarity.
6) Mudaraba companies
▪
Similar to that of closed-end fund managed by specialized professional
management companies. Unlike the Islamic bank, they are not allowed to
accept deposits. Funded by equity capital.
▪
Two types; Multipurpose (more than one investment purpose) and Specific
purpose.
Future Challenges
1) Liquidity
▪
Liquidity- enhancing financial instruments & the development of capital
market.
2) Limited scope
▪
Can benefit from economies of scale &enhancement of scope. Both
approaches offer diversification benefits.
3) Concentrated financing
▪
Diversifying their base of depositors, reduce their exposure, introduction of
Internet banking, geographical diversity on the liabilities side.
4) Concentrated banking
▪
Risk management framework can be enhanced by improving the
transparency in current financial disclosure.
▪
Measurement & management of risk need to be supplemented with
analytical method.
Areas of improvement & steps forward
✓ To enhance Financial Engineering that includes the design, development &
implementation of innovative financial instruments, new securities or new process
of creative solution to corporate finance problems, provided to be Shariah
complaint.
✓ There is need to establish supporting institutions to act as a Lender of Last Resort .
✓ There is need to achieve Uniformity in, & Harmonization of, Shariah Standards
across markets & borders.
✓ To develop Fee -Based Services like, Joalah, Wakalah & Kifalah to exploit the full
capabilities of Islamic banks by diversifying the scope of non bank financial
services.
✓ Developing benchmarks based on the rate of return reflecting Islamic modes of
financing instead of using interest base benchmarks such as the London interbank
offered rate (LIBOR) which has been accepted on an adhoc based.
✓ Creating a secondary market to enhance the liquidity, & standardizing contracts,
to reduce the risk of asset backed securities.
✓ Standardizing the operations & instruments will pave the way for pooling assets,
much needed for enhancing liquidity in the market.
✓ By expanding the scope of services, Islamic bank could spread the fixed costs since
they are similar to universal banking in a form of hybrid between commercial &
investment banking.
✓ Having a Shariah board for every institution is not efficient. A Shariah board for
the system as a whole is needed to ensure that rules are defined & enforced in
compliance with the contractual obligations to all stockholders.
✓ Well developed Islamic capital market will benefit borrowers, institutional
investors, together with enhancing the stability of Islamic banks.
✓ A well developed Islamic microfinance industry will promote economic
development in underdeveloped Islamic countries, also it will economically
empowered the poor segments of society since they will be able to move from being
non-bankable to bankable, this will expand the base of the depositors & investors.
Chapter 2: Islamic Economics
It is a branch of knowledge which helps to realize human well – being through an
allocation and distribution of scarce resources that is in conformity with Islamic
teachings without unduly curbing individual freedom or creating continued
macroeconomic and ecological imbalances.
Also according to Chapra and many other Scholars; there are 4 sources of Islamic systems;
they are;
Islamic economics or Islamic commercial jurisprudence or fiqh almu'āmalāt refers to the rules of transacting finance or other economic activity in a Shari'a
compliant manner, i.e. a manner conforming to Islamic scripture (Quran and sunnah). Islamic
jurisprudence (fiqh) has traditionally dealt with determining what is required,
prohibited, encouraged, discouraged, or just permissible, according to (what
Muslims believe to be) the revealed word of God (Quran) and the religious practices
established by the (Islamic) Prophet (sunnah).
This applied to issues like property, money, employment, taxes, along with everything else. The
central features of an Islamic economy are often summarized as:
1) the "behavioral norms and moral foundations" derived from the Quran and Sunnah;
2) collection of Zakat and other Islamic taxes,
3) prohibition of interest (riba) charged on loans.
In islamic economic system by Islamic activists and revivalists are that the gap between the rich
and the poor will be reduced and prosperity enhanced by such means as the discouraging of the
hoarding of wealth, taxing wealth (through zakat) but not trade, exposing lenders to risk through
Profit sharing and venture capital, discouraging of hoarding of food for speculation, and other
sinful activities such as unlawful confiscation of land.
Objectives of Islamic economics
a.
b.
c.
d.
Economic well-being and the moral norms of Islam;
Universal brotherhood and justice;
Equitable distribution of income; and
Freedom of the individual within the context of social welfare.
Imam Al-Ghazali, an Islamic philosopher, contended that the very objective of the Islamic
jurisprudence is to promote the welfare of the people which lies in safeguarding their faith, their
life, their intellect, their posterity and their property; and that therefore whatever ensures the
safeguard of these five serves public interest and is desirable.
The main objective of islamic economy is to follow maqasid al-shari’ah thats target
is to promote the welfare of human beings, which lies in safeguarding their religion,
selves, minds, progeny and wealth. Whatever ensures and safeguards these five
fundamentals serves public interest and is desirable. Whatever hurts them is against
public interest and its removal is desirable. (Al-Ghazali).
The structural elements of maqasid in islamic economy are explained below:
1.Religion: The vision of well-being
Needs and embellishment take such as effect on religion as long as the worldview of shari’ah
extends through ijtihad to encompass are ideas, rules, measures and values to match rising
economic wants in the everlasting endeavour to satisfy those.
2. Self: The central goal
“Self” is human life which is the goal of well-being as implied by the verse: ”It is He who created
for you all of that which is on earth.” (Al-Qur’an, 2:29). Qur’an says: “We have certainly honored
the children of Adam and carried them on the land and sea and provided for them of the good
things and preferred them well over much of what we have created” (Al-Qur’an: 17:70).
3. Mind: The human resource
Mind is the human resource that thinks, evaluates, plans, manages and produces the goods
(tayyibat) of well-being subject to shari’ah. The first five verses to Muhammad (p.b.u.h.) are:”read
in the name of your Lord who created, - created man from a clinging substance. Read and your
Lord is the most Generous, Who taught man by pen. Taught man that which he knew not” (AlQur’an 96:1-5).
4. Progeny: Intergenerational continuity
Intergenerational responsibilities depend on family, and social and government institutions in
lobbying people’s support. The guiding principle is the Qur’anic verse: “ Let the one of means
spend according to his means: and the one whose resources are restricted, let him spend according
to what Allah has given him. Allah puts no burden on any person beyond what He has given him”
(Al-Qur’an 65:7).
5. Wealth: The material economic resource
Material economic resources must run abundantly in the economy to activate human resources in
the pursuit of well-being and intergenerational continuity. Wealth is the mean to achieve goals and
targets of human being. Shari’ah recognizes and fosters all customary rights of private property
under the provision that wealth is a trust from Allah (s.w.t.) to test how his servants deliver moral
and social obligations through the management of their wealth. “ Believe in Allah and His
messenger, and spend out of what He has made you vicegerents”(Al-Qur’an 57:7).
Why Islamic economics?
The modern industrial environment has brought with it unprecedented socioeconomic problems
affecting human well-being beyond the traditional shari’ah scholars, even though the core
principles of islamic economics originated in the works of early shari’ah scholars who laid down
the foundations of maqasid and utility theory. Islamic economics is therefore, a newly emerging
discipline that takes the lead in resolving newly arising economic issues from the viewpoint of
maqasid that has emerged to satisfy new needs in relation to the mind, the productive human
resources.
The Three Central Economic Problems
1. Production decision (What to produce) – it covers nature, volume and pricing of goods.
“Prices are fixed by God. He alone contracts and expands the means of livelihood, and I
wish to meet my sustainer having no claim of injustice being made against me in respect
of blood and wealth.”
2. Management decision (How to produce) – islamic economy prohibits riba and
emphasised on risk-sharing through mudarabah and musharakah rather than external debt
financing
3. Distribution decision (For whom to produce)- in islamic economics there are wage, rent
and profit for different factors of production. Money capital shares the same income and
profit with the entrepreneur on a PLS basis thereby giving room to favorable distributional
consequences in terms of employment and labor-friendly technology. In this economy for
ensuring justice there will be applying zakat and waqf those will minimize poor-rich gap
in the society.
Economics of Riba (Negative Impact of Riba)
1) Riba is any earning, income, profit or benefits being earned, taken or received through wrong
means, bad intentions, shady practices or wicked participation.
2) Ii. It is not only treated as immoral, unjust filthy but furthermore threat to socioeconomic life
of the society.
3) It leads to crimes of various nature, through cruelty, humiliation, exploitation, self- importance,
discrimination, power, selfishness, greed and self-esteem.
4) It is as a combination of evil and sins and bad practice to earn & gain.
5) It brings instability in the community life and the source for the increase of inflation.
6) It is immoral, unethical, unjustified commercial, economical, trading, business, political,
social, cultural and traditional practices and activities to gain benefit at individual, collective
or institutional level. People who indulge in riba shall be raised like those who have been driven
to madness by the touch of devil. That is because they say that riba-based transaction is just
like trading, while Allah has permitted trade and prohibited riba. Hence those who have
received the warning from Allah and have stop accordingly, may have what has already passed,
their case being entrust to Allah but those who revert to riba-based dealings, shall be the
inhabitants of the hell-fire and abide therein forever. (You must know that) Allah deprives riba
from all blessings and blesses charity; He loves not any ungrateful sinners. In Holy Qur’an
(2:278-79), Allah says, “O you believers! Fear Allah and give up riba that remains outstanding
if you are true believers. Watch out, If you do not obey this directive, then Allah declares war
against you from Himself and from His Prophet. But, if you give up your outstanding riba,
then you can claim your principals. Neither should you cause harm with riba to others, nor
should others harm you. Prophet Muhammad (May Peace Be Upon Him) said at the last
Pilgrimage, all riba of jahilliya is null and void. In this respect, the first riba I (May Peace Be
Upon Him) withdraw that the borrowers owe to my uncle Abbas; it is cancelled completely.
(Muslim) The Prophet (May Peace Be Upon Him) cursed all those who take riba, who give
riba, who write a riba contract and the two witnesses to a riba contract. He (May Peace Be
Upon Him) further said: "They are all alike (in fault).
7) Riba must be eliminated from the financial transactions. Nothing is more horrific as compared
to riba that Islam has prohibited. Nothing is more dreadful than riba, is remains in widespread
threatening socio-economic activities in both theory and practice.
Economics of Financial System
Financial system is a complex set of financial institutions and markets that bring
together lenders and borrowers consisting of banks, insurance companies, mutual
funds and other finance companies. The main objective of this system is to mobilise
large amounts of relatively small savings and pool them together to channel them
for productive investments in the economy directly through markets or indirectly
through financial intermediaries. Financial institutions also develop instruments, techniques
and products that meet the needs of both lenders and borrowers. Central banks also carry out
monetary policies through financial institutions for supporting economic growth of the country by
producing goods and services and creating employment.
The structure of Islamic Financial System
Under islamic financial system, islamic financial markets, institutions and instruments operate in
line with shari’ah rules and principles. This system is governed by the following factors :
a) Transaction cost- costs incurred for financial structuring, legal documentation, accounting
treatment and administrative follow-up.
b) Economic information- past track records, current financial position and future investment
prospects
Islamic Financial Markets
Financial market mechanism deals with different types of financial instruments for exchanging
funds from surplus units to deficit units by complying with shari’ah rules and principles specially
eliminating riba, gharar and maysir is known as islamic financial market
Islamic Financial Institutions
Financial institutions deal with different types of financial instruments for
exchanging funds from surplus units to deficit units by complying maqasid of
islamic financial system specially eliminating riba, gharar and maysir for achieving
goals of financial system are known as islamic financial institution.
Role of Islamic Financial Institutions
i.
To make a link between surplus groups and deficit groups.
ii.
To collect relatively small savings from individuals and institutions and transfer them
to businesses for investment and production purposes.
To gather and process information about the economic conditions of markets as well
as market players.
To ensure market efficiency by reducing cost for raising funds and maximizing return
on investment.
To transform relatively short-term liabilities into long-term assets.
To facilitate the mitigation, transfer and sharing of risk.
To provide maturity intermediation.
iii.
iv.
v.
vi.
vii.
Distinct features of Islamic Financial Institutions
1. Islamic financial institutions use various contracts that are in line with shari’ah teachings.
2. They use equity as well as debt-based financial instruments for the mobilisation and use
of funds.
3. They buildup and maintain long-term relationships in profit-and-loss sharing
arrangements.
4. They may imply higher costs and unique risks.
5. They face certain risks that are associated with specific business models and islamic
contracts in financial intermediation.
6. They are faced with the rate of return risk, displaced commercial risk, fiduciary risk,
shari’ah compliance risk and reputation risk.
7. Existence of shari’ah advisory board that approves introduction of any new product.
Islamic Financial Instruments
From the shari’ah point of view, every contract is considered to be legal and lawful as long as it
does not contain any prohibited elements, such as riba, gharar and maysir. Islamic instruments are:
A: Deposit instruments- Al-Wadeah current account (AWCA), Mudarabah savings account
(MSA), Mudarabah term depost account (MTDR), Mudarabah special notice account (MSNA),
Mudarabah hajj savings account (MHSA), Mudarabah special savings account (MSSA),
Mudarabah savings bond (MSB), Mudarabah monthly profit deposit account (MMPDA),
Mudarabah monthly savings account (MMSA), Mudarabah waqf cash deposit account
(MWCDA), Mudarabah NRB savings bond account (MNSB), Mudarabah foreign currency
deposit account (MFCDA), Students mudarabah savings account (SMSA), Mudarabah farmers
savings account (MFSA).
B: Investment instruments:
i.
Bai modes- Bai-Murabaha, Bai-Istijrar , Bai-Muajjal, Bai Salam, Istisna’a, Bai-As-Sarf
ii. Share modes - Mudaraba, Musharaka
iii. Ijara modes - Hire Purchase Under Shirkatul Melk
iv. Investment Scheme- House Hold Investment Scheme, Investment Scheme for Doctors (ISD),
Transport Investment Scheme (TIS), Car Investment Scheme (CIS), Small Business Investment
Scheme (SBIS), Micro Industries Investment Scheme (MIIS), Agricultural Implement Investment
Scheme (AIIS), Real Estate Investment Program (REIP), Real Estate Investment (Commercial &
Working Capital), Agricultural Investment of IBBL , NRB (Non Resident Bangladeshi)
Entrepreneurs Investment Scheme(NEIS), Women Entrepreneurs Investment Scheme (WEIS)
v. Rural Development Scheme
Differences between Islamic and conventional banking
1. The functions and operating modes of conventional banks are based on fully manmade
principles whereas the functions and operating modes of Islamic banks are based on the
principles of Islamic Shariah.
2. The investor is assured of a predetermined rate of interest, whereas in contrast, it promotes
risk sharing between provider of capital (investor) and the user of funds (entrepreneur).
3. It aims at maximizing profit without any restriction, whereas it also aims at maximizing
profit but subject to Shariah restrictions.
4. It does not deal with Zakat, whereas in the modern Islamic banking system, it has become
one of the service-oriented functions of the Islamic banks to be a Zakat Collection Centre
and they also pay out their Zakat.
5. Lending money and getting it back with compounding interest is the fundamental function
of the conventional banks, whereas participation in partnership business is the fundamental
function of the Islamic banks. So we have to understand our customer's business very well.
6. It can charge additional money (penalty and compounded interest) in case of defaulters,
whereas the Islamic banks have no provision to charge any extra money from the
defaulters. Only small amount of compensation and these proceeds is given to charity.
Rebates are given for early settlement at the Bank's discretion.
7. Very often it results in the bank's own interest becoming prominent. It makes no effort to
ensure growth with equity, whereas it gives due importance to the public interest. Its
ultimate aim is to ensure growth with equity.
8. For interest-based commercial banks, borrowing from the money market is relatively
easier, whereas for the Islamic banks, it must be based on a Shariah approved underlying
transaction.
9. Since income from the advances is fixed, it gives little importance to developing expertise
in project appraisal and evaluations, whereas since it shares profit and loss, the Islamic
banks pay greater attention to developing project appraisal and evaluations.
10. The conventional banks give greater emphasis on credit-worthiness of the clients, whereas
the Islamic banks, on the other hand, give greater emphasis on the viability of the projects.
11. The status of a conventional bank, in relation to its clients, is that of creditor and debtors,
whereas the status of Islamic bank in relation to its clients is that of partners, investors and
trader, buyer and seller.
12. A conventional bank has to guarantee all its deposits, whereas islamic bank can only
guarantee deposits for deposit account, which is based on the principle of al-wadiah, thus
the depositors are guaranteed repayment of their funds, however if the account is based on
the mudarabah concept, client have to share in a loss position.
Chapter 3 Development of Islamic Financial System
Historical overview of Islamic finance:
In the late 19th Century, the Ottomans introduced western-style banking to the Islamic world to
finance their expenditures. While some Islamic jurists approved of modern banking practices, the
majority found those practices to be violations of Islamic prohibitions against usury i.e. Riba. This
resentment continued through the European colonial period, which lasted into the mid-20th
Century. Islamic revival played a central role in the intellectual and social foundations of
independence movements of the mid-20th Century. To many intellectual founders of the
movement, political independence was to be supplemented with economic independence, through
the definition of an Islamic economic system.
Early writings on what came to be known as “Islamic Economics” focused on macroeconomic
developmental issues. By the 1970s, theoretical discussions of Islamic economics had given rise
to practical discussions of Islamic finance, which turned juristic in nature: how can Muslims
replace (conventional) financial practices (deemed to be usury/riba-based) with Islamic
alternatives. Mid-Century literature suggested a profit-and-loss sharing silent partnership
alternative to interest-based lending. The Arabic name of this contract is mudaraba, which is akin
to the medieval European Commenda contract, and the Jewish Heter Isqa, designed similarly to
avoid usurious lending in Jewish and early Catholic Law. This partnership-based focus survives
in some Islamic financial practices . However, with the help of Islamic jurists and lawyers, Islamic
financial practitioners were soon able to provide close analogues to almost all financial products,
including various debt-instruments and fixed-income investment vehicles.
Year-wise development of Islamic finance:
650 A.D. - 750 A.D.: During the time of Holy Prophet Muhammad (Peace be upon him); During
the time of Holy Companions (Ra) and Khulfa –e- Rahidoon; After the period of Companions
(Ra). Biatul-Maal, Zakat, Jizyah, Kharaj, Warik, Bills and Cheques.
750 A.D. - 1900 A.D.: International Trade spread over Rome, Tunisia, Turkey, India and Sumatra;
Musharaka contracts, Sukuk, Saftija, Bay al-Wafa, Bay al-Nuqud, etc, were practiced.
1900 A.D. - 2000 A.D.: Demand for interest free banking system; Theoretical works by scholars;
Establishment of first-generation institutions such as societies, banks and funds in Egypt, India,
Pakistan, Malaysia, Dubai, Saudi Arabia, Iran, Sudan, etc.
2000 A.D. till date: Growth and expansion of Islamic financial institutions; Establishment of the
various Islamic Finance Institutions.
Modern Day Islamic Finance
The growth of modern islamic banking can be attributed to three factors such as: 1) the rise of oil
prices after 1974 has seen a number of Arab and Muslim countries experiencing a rise in national
income, economic activity and greater investment; 2) Muslims would not want to put their money
into interest-based financial system and 3) colonialism free countries faced rapid industrialization
and urbanisation.
i.
ii.
iii.
Islamic banks coexisting with interest-based banks in Kazakistan, Egypt, Qatar,
Bahrain, Bangladesh
Conventional banks introduced “Islamic Windows” in Malaysia, Qatar, Egypt and
Bangladesh
Entire banking system based on shari’ah in Sudan, Iran, Malaysia, Pakistan, Egypt,
Dubai, Jordan, Bahrain.
Along with islamic banks there are islamic insurance companies and islamic investment companies
are operating in different countries based on shari’ah.
Emerging Interest in Islamic Finance in Other Jurisdictions Today
Islamic finance has been registered in Muslim countries, East Asian countries, Western Europe,
Hong Kong and UK. France and Japan have made changes to their laws and regulatory frameworks
to facilitate the introduction of islamic financial products into their markets. The Commonwealth
of Independent State (CIS) countries such as Kazakhastan, Kyrgystan and Tajikistan are emerging
and proactive in developing islamic finance in their markets. Kenya, Tanzania and Uganda have
reoprted growing interest in islamic finance while Australia, Mauritius and Sri Lanka have
expressed an interest in developing their countries’ islamic financial markets.
International infrastructure institutions
1. Accounting and Auditing Organization for Islamic financial institution
(AAOIFI): The AAOIFI is a non-profit organization that focuses mainly on the area of
accounting and auditing for Islamic financial institutions. While recognizing the need for
standards, AAOIFI was established on February 1990 in Algeria and was registered on March
1991 in the kingdom of Bahrain. The organization is supported by 200 institution members from
45 countries across the global. The AAOIFI is one of prominent Islamic agency that attempts to
install accounting and auditing standard for Islamic financial industry. The main object is to
develop and disseminate accounting and auditing thought relevant to Islamic financial institutions
and their applications. Its tasks include holding seminars, publishing periodicals, newsletters,
commissioning research and prepare, promulgate, interpret and review, the accounting and
auditing standards for Islamic financial institutions. AAOIFI has issued: 26 Accounting standards,
5 Auditing standards, 7 Governance standards, 2 code of ethics and 41 shariah standards.
Its notable efforts are to inform and encourage banking supervisors around the world to adopt its
standard as the benchmark for Islamic financial institutions in their countries. These attempts to
improve the transparency and comparability of the financial reporting of Islamic financial
institutions are bearing fruit. The AAOIFI’s standard has been applied in various countries such
as Bahrain and Sudan which require Islamic Banks in their countries to follow AAOIFI’s
standards. In Qatar and Saudi Arabia AAOIFI’s standards are specified as guidelines. To achieve
international recognition for its standard, AAOIFI has also been working with conventional
international bodies which involve in the development of standards and regulation of banks such
as the International Monetary Fund, International Accounting Standards Board, and the Basel
Committee. The organization plays a crucial role in harmonizing the Islamic financial institution
practices with the international accepted practices.
2. The International Islamic Financial Market (IIFM) :
Recent development for Islamic financial markets was made in 2001 when the Bahrain Monetary
Agency (BMA) signed a Memorandum of Understanding with the Islamic Development Bank, the
Labuan Offshore Financial Services Authority (LOFSA), Bank of Sudan, and Brunei Ministry of
Finance to sponsor the establishment of a multilateral international financial market. As the result,
the International Islamic Financial Market (IIFM) was established and headquartered in Bahrain.
It main aim has been to provide global standard and cooperative framework for the Islamic
financial market and to ensure the continued growth of the market in line with Shari’ah rules and
principles, by promoting the harmonization and convergence of Shari’ah interpretation in
developing Islamic banking products and practices which are universally acceptable. It has also
persuaded Islamic financial institutions in the market to introduce a wide range of Shari’ah
compliant products and the creation of an active secondary market which creates liquidity for
instruments traded in the market. It is active in the establishment, and development of settlement
related system infrastructure and increasing trading value of Islamic financial market. It also
involves itself with several challenging issues for Islamic financial market including Islamic
hedging, secondary market documentation and the creation of innovative products, an Islamic repo
market, treasury, murabahah contract mechanisms and similar elements vital to a well- developed
and functional Islamic financial system.
3.General Council for Islamic Banks and Financial Institutions (CIBAFI):
It was established in 2001 in Bahrain as an international nonprofit organization which supports
and promotes the islamic financial services industry through information, media, research and
development, consultancy and human resources development. Since its establishment, it has
supported the industry with the establishment of the International Islamic Centre for Conciliation
and Commercial Arbitration in Dubai in 2004 that aims to settle financial and commercial disputes
between concerned parties that have chosen to comply with the shari’ah to settle disputes. It laso
contributed in establishing a department for islamic banking in the US Treasury Department in
2002, building a database containing historical administrative, financial and statistical information
about IFIs and launching the Quality Certificate Project for islamic products.
4.Islamic Financial Services Board (IFSB): The Islamic Financial Services Board is an
international body based in Kuala Lumpur, Malaysia, and it began its operations in March 2003.
The institution is working as international standard setting body of regulatory and supervisory
agencies that have their main interest in ensuring the effective performance and stability of the
Islamic financial services industry covering the area of banking, capital market, and insurance.
The members of IFSB include 49 regulatory and Supervisory authorities in addition to Islamic
Development Bank, Asian Development Bank, Islamic Corporation for the Development of
Private Sectors, the International Monetary Fund, World Bank, and Bank for International
Settlements, and 138 market players and professional firms operating in 39 countries across the
world. The primary target of IFSB is to develop uniform regulatory and transparency standards to
address characteristics specific to Islamic financial institutions, keeping in mind the national
financial environment, international standards, core principles, and good practices. The IFSB has
also been enhancing awareness of issues that are pertinent to or have an impact on the regulation
and supervision of the Islamic financial services industry. In short, the performance of IFSB is
divided into three main areas:
a) Regulatory perspective
b) Coordination and harmonization perspective
c) Training and research perspective
5. International Islamic Rating Agency (IIRA): In responds to the sound expansion of
Islamic financial services industry, The Islamic Development Bank (IDB) established the
International Islamic Rating Agency in October 2002 in Bahrain. The IIRA was expected to be an
international body to provide infrastructure assistance to Islamic capital markets by providing an
assessment of the risk profile of entities and instruments that can be used for investment decisions.
IIRA does rating, evaluating and providing independent assessments and opinions on the
likelihood of future of any Islamic financial institutions as well as their products and services. It
also publishes and discloses to the public the data and information relating to rated entities and
financial instruments. IIRA will also assess the Shari’ah compliant aspects of Islamic financial
institutions and Islamic financial products.The IIRA is sole rating agency established to provide a
rating spectrum that surrounds and deals with the full rank of capital instruments and specialised
Islamic financial products.
6. International Islamic Liquidity Management Corporation(IILM):
Its an international entity established to issue short-term shari’ah-compliant financial instruments
to facilitate more efficient liquidity management for institutions offering islamic financial services
and to support the increasing cross-boarder transactions between these institutions. Its membership
is open to central banks, monetary authorities, financial regulatory authorities, government
ministries that have regularly oversight on finance or trade and commerce, and multi-lateral
organizations which will hold shares of IILM.
7.Liquidity Management Center (LMC):
To enable Islamic financial institutions to manage their liquidity through short and medium term
liquid investments that are structured in conforming to the Shariah laws. The LMC was established
for the purpose of facilitating the investment of the surplus funds of Islamic banks and financial
institutions into quality short and medium term instrument as well as supports the interbank
markets. Liquidity Management Centre (LMC) was established on July 29th, 2002 in the Kingdom
of Bahrain as a Bahraini joint stock company with an Islamic Investment Banking license. It’s cofounder include Bahrain Islamic Bank (Bahrain), Dubai Islamic Bank (United Arab Emirates),
Islamic Development Bank (Saudi Arabia), Liquidity Management House (Kuwait).
8.Islamic Research and Training Institute (IRTI):
The Islamic Research and Training Institute was established by the Islamic Development Bank at
Jeddah in 1981. Its main functions are to organize and coordinate basic and applied research with
a view to developing models and methods for the application of Shariah in the field of economics
finance and banking and to provide training in Islamic economics for personnel in development
activities in the member states. IRTI's objectives are: to undertake research and provide training
and information services in member countries and Muslim communities in non-member countries
to help bring their economic, financial and banking activities into conformity with Shariah and to
further accelerate economic development and enhance cooperation amongst them.
Models of Islamic Finance
Regulators have allowed dual systems whereby they issue some additional policies and regulations
for IFIs in addition to the prudential regulatory framework for conventional banks. Within this
category there are variations with regard to the role of regulators in shari’ah compliance. Some
countries have decalred the entire financial system to be islamic while in others, no distinction is
made between islamic or conventional financial systems. Countries like UK and Singapore have
introduced specific regulations to facilitate islamic finance transactions. Some regulators issue a
standard form of banking licenses (Saudi Arabia) for both islamic and conventional institutions,
while others (Malaysia) issue separate islamic banking licenses. This may be (i) Market-Driven
versus government initiatives and (ii) Full-Fledged versus dual banking system.
Infrastructure for Development
The rapid expansions of the islamic financial system are actively promoted through deregulation
and legal reforms that may give an incentive to foster the development of financial intermediaries
and markets. This development process includes the followings:
1. Appropriate regulatory and supervisory framework: An effective regulatory and
supervisory framework for supporting the stability of the financial system is required for a welldeveloped financial infrastructure. For example, islamic bank activities and banking-commerce
links, domestic and foreign islamic bank entries, capital adequacy, deposit insurance, regulations
on easing private sector monitoring of islamic banks and government ownership of islamic banks.
2. Existence of strong corporate governance: Effective corporate governance practices
are essential to achieve and maintain public trust and confidence in the banking system. From a
banking industry perspective, corporate governance involves the manner in which the business and
affairs of a bank are governed by its board and senior management. Islam strongly advocates all
forms of positive governance and these values have already been built in and are inherent in the
community. Islamic corporate governance serves through its underlying principles of the economic
well-being of the ummah, universal brotherhood, justice, accountability and equitable distribution
of income.
3. Greater transparency and disclosure of information: Transparency could be
defined as public disclosure of reliable and timely information that enables users of that
information to make an accurate assessment of a bank’s financial condition and performance,
business activities, risk profile and risk management practices. To achieve transparency, a bank
must provide timely, accurate, relevant and sufficient disclosures of qualitative and quantitative
information the enables users to make proper assessment of the institutions activities and risk
profile. In promoting transparency, supervisors and regulators need to design effective disclosure
standards.
4. Risk management framework: The identification and assessment of risks and the
determination of risk mitigation and management strategies form an essential part of the risk
management framework of a financial institution. The FASB has issued the guiding principles of
risk management for offering islamic financial services. The Basel Committee on banking
supervision standards has set out sound practices and principles pertaining to credit, market,
liquidity and operational risks of financial institutions.
5. Effective and dynamic shari’ah framework: The shari’ah framework includes
governance structures, processes and arrangements to ensure that all islamic financial instituions’
operations and business activities are in accordance with the shari’ah. The structure and processes
include:
1. Rules governing the composition and qualifications of shari’ah committee members of the IFI.
2. Issuance of relevant shari’ah resolutuions that govern whole of its operations.
3. An internal shari’ah compliance review/audit for verifying that shari’ah compliance has
been satisfied, during which any incident of noncompliance will be recorded and reported.
4. Dissemination of information on such shari’ah pronouncements/resolutions to the
operative personnel of the IFIs.
Development of Vibrant Islamic Financial Markets
The development of an islamic financial system should include key components comprising the
islamic money market and the islamic equity and debt capital market. The equity and bond markets
will contribute towards a more efficient distribution of risk within the system, thus creating
stability in the system. Complementing these financial markets is the development of non-bank
islamic financial institutions such as insurance companies, savings institution s, housing credit
institutions need to be developed to meet increasingly diversified customer demand. It includes
the followings:
1)
2)
3)
4)
5)
Large number of playersWide range of financial products and instrumentsTax neutrality
Blue print for islamic finance i.e. long-term master plan
Accounting and auditing standards for islamic financial institutions (AAOIFI)
Challenges (for development of financial system):
Islamic finance faces a number of challenges that need to be addressed to sustain its development
in the global financial system such as:
1)
2)
3)
4)
Adoption of a robust domestic islamic financial system
Efficient and active international islamic financial markets
Availability of a wide range of instruments (shari’ah compliant products)
Human resource requirements
Chapter 4: Shari’ah Framework and Principles for the Islamic
Financial System
Definition of shari’ah:
Sharia or sharia law (‫ )شريعة‬is the Islamic legal system derived from the religious precepts of
Islam, particularly the Quran and the Hadith. The term sharia comes from the Arabic language
term sharīah, which means a body of moral and religious law derived from religious prophecy, as
opposed to human legislation. It deals with many topics, including crime, politics, and economics,
as well as personal matters such as hygiene, diet, prayer, everyday etiquette and fasting. Adherence
to sharia has served as one of the distinguishing characteristics of the Muslim faith historically.
In its strictest and most historically coherent definition, sharia is considered in Islam as the
infallible law of God. Literally it means “the road to the watering place”. According to Qur’an;
“Then We have put you on a plain way (‫ )شريعة‬of commandment. So follow you that ( Islamic
monotheism and its laws), and follow not the desires of those who know not.” (Al-Qur’an, 45:18).
It is the sum of the islamic teachings and system, which was revealed to prophet Muhammad
(Pbuh), recorded in the Qur’an as well as deducible from the prophet’s divinely-guided lifestyle
called the sunnah.
Components of Shari’ah
The Shari’ah, which contains all different commandments of Allah (swt) to mankind, can be
divided into three fields such as:
1) Al-ahkam al-taqdiyyah i.e. the sanctions relating to beliefs such as the belief in Allah (swt)
and the day of judgement,
2) Al-ahkam al-akhlaqiyyah i.e. the sanctions relating to morals and ethics such as the
injunction to the truth, be sincere, be honest etc.
3) Al-ahkam al-amaliyyah i.e. sanctions relating to the sayings and doings of the individual
and his relations is called fiqh.
Sources of Islamic Law (Shari’ah)
A: Primary sources – Qur’an, Sunnah, Ijma and Qiyas.
B: Secondary sources – juristic preference (istihsan), presumption of continuity (istishab), custom
(urf), consideration of public interest (maslahah al-mursalah), blocking of means (sadd al-dhara’i),
and the practice of the people of Madinah (amal ahl al-Madinah).
Maqasid Al-shari’ah vis-à-vis Islamic finance
Maqasid Al-shari’ah is defined as “the deeper meanings and inner aspects of wisdom (hikam)
considered by the lawgiver in all or most of the areas and circumstances of legislation”. It
also explained the importance of the knowledge of maqasid al-shari’ah for mujtahids not only in
understanding and interpreting the text of shari’ah, but also to find solutions to the new problems
facing muslims and about which those text are silent.
In islamic finance and banking, equity-based financing like musharakah and mudarabah are closer
to the realization of maqasid al-shari’ah. On the other hand, debt-based personal financing like
ijara transactions, sale transactions and bay’ al-inah are not fully in line with maqasid al-shariah.
In most situations, the customers are in real need of cash for some legitimate purposes for inah and
tawarruq are shari’ah compliant.
Legal maxims pertinent to Islamic finance
Legal maxims are defined as the general fiqh principles which are presented in a simple
format consisting of the general rules of shari’ah in a particular field related to it. The
function of legal maxims is to facilitate the understanding of how problems and principles could
be used to deduce the many rules of fiqh. These are formulated based on certain evidences from
the Qur’an or Sunnah. For example, “The burden of proof is on him who claims, and the oath is
on him who denies.” These are also constructed upon principles of pure justice, interest of
human beings and principles are generally confirmed by the shari’ah.
Modern issues in islamic finance which have no precedent from the classical texts arise from time
to time and these issues need to be addressed according to islamic rulings. Thus the solution is
founded in the application of legal maxims to develop the parameters of islamic banking and
finance and its general principles. Generally following five legal maxims are
considered as unanimously accepted for covering the most issues of fiqh:
1. Matters are determined according to intentions (Al-umur bi maqasidiha): This is originated
from “Deeds are judged by intentions and every person is judged according his intention” (Al
Bukhari).
All human acts, once done, must be valued in accordance with intention. The intention of the
parties in a transaction is relevant in determining its legal effect. An example of this in modern
banking is the imposition of ta’widh that is the compensation paid by the intentionally defaulting
parties that is allowed on the basis of preventing intentional defaults by customers.
2. Hardship begets facility (Al-mashaqqatu tujlab at-taysir): Difficulty is to be accompanied
by easiness. Necessity renders prohibited things permissible. According to this, exceptions must
be granted in order to avoid the injustice.
“Allah has not laid down upon you in religion any hardship” (Surah Al-Hajj, 78). Also “He
intends every facility for you, and he does not want to put you in hardship”, (Surah Al-Baqara,
286). This is found to be of important relevance in modern islamic finance, for example, the
permission to deal with conventional banking for the muslim minority living in non-muslim
countries to some extent.
3. Harm should not be inflicted nor reciprocated (La darara wa la dirar): It means injurious
or harmful acts must be avoided and prevented in all cases. Based on this principle, the debtor’s
act of delaying payment which could harm the creditor must be avoided by having a
compensation/penalty clause.
4. What is certain cannot be removed by doubt (Al-yaginu la yuzala bi ash-shakk): This is
pertinent in solving the cases of doubt. The origin of all things is permissibility. It means all things
or creatures in this world are permissible for consumption or use by humans, unless Allah says
otherwise. The Qur’an states in Surah Al Baqarah, verse 29: “And he has created for you every
creation on earth.” In sunnah, The Prophet (pbuh) said, “What is permitted by Allah in the Qur’an
is halal and what is prohibited is haram, what is left unmentioned is permitted so accept the leave
given by Allah, verily Allah does not forget anything.” This rule widens and paves the way for the
innovation of different tools and instruments for financial transactions without necessarily finding
the authority for their permissibility.
5. Customary practices as a basis of judgements (Al-adatu muhakkamatun): Customary
practices of society in terms of their words and actions are acknowledged and recognised by the
shari’ah in the absence of textual injunction, provided they have fulfilled the following
requirements:
a) The custom must not violate a divine text of the Qur’an and Sunnah or any shari’ah principles.
b) The custom must be consistently applied and prevailing in the society.
c) The custom must have been in effect at the time the activity or transaction was carried out.
d) The two contracting parties must not have agreed to a condition contrary to the customary
practice. If they have agreed to the contrary, then the customary practice is not recognised.
Differences of opinion among scholars
The differences of opinion among the jurists take place in all stages of the development of islamic
jurisprudence. The nature of textual evidences either from the Qur’an or Sunnah allows room for
differences of opinion. It is natural that muslims across the eras and jurisdictions have differences
of opinion in economic transactions law, even from the early stage of islamic laws development
in the hands of the early jurists. With regard to modern islamic finance and banking, the difference
across jurisdictions as well as among individual jurists is an acceptable fact. This is due to the fact
that modern islamic finance emerged amidst the complicated conventional system, striving to
provide alternatives to muslims.
Basically, there are four main reasons for
conflicting rulings among the jurists:
a)
b)
c)
d)
Variation in understanding the meaning of a word in the texts
Differences over the narrations of the Sunnah
Conflict in the application of principles
Divergence in the method of Qiyas
Role of ijtihad and mujtahid in Islamic banking and finance
It is an effort made by the mujtahid in seeking knowledge of the legal rules of shari’ah through
interpretation. Thus, ijtihad entails the effort made by the qualified scholars in order to derive
rulings, by using the principles of interpretation of law known as usul al-fiqh. Ijtihad might need
to be performed collectively. Modern issues like islamic finance might need collective rather than
individual ijtihad. This is classified as:
a) Ijtihad to discover the laws directly from the text whether it is explicitly or impliedly
mentioned by the text. This involves direct interpretations by the mujtahid on the
specific meaning of the available text.
b) Ijtihad to extend the law to new cases that might be mentioned in the text requires to
apply qiyas by looking at the illah or underlying rationale.
c) Ijtihad to extend the law to new cases that are not covered by the previous two methods
by extending the general principles of law or maqasid al-shari’ah as laid down by the
text. Many issues of modern islamic finance fall within this type of issue, and hence
necessitate the exercise of collective ijtihad.
Fundamental prohibited elements in islamic finance
1. Prohibition of ribaRiba literally means excess, expansion, increase, addition or growth. It could be defined as
unlawful gain derived from the quantitative inequality of the counter values in any
transaction purporting to affect the exchange of two or more species which belong to the
same genus and governed by the same efficient cause.
Riba may be the following two types:
a. Riba al –duyun or riba al-nasi’ah (Lending-borrowing)
b. Riba al-buyu’ or riba al-fadl ( Trading or exchanging)
2. Prohibition of ghararLiterally it means risk, uncertainty and hazard. A contract which contains a risk to any one of
the parties which could lead to his loss of property is known as gharar. “O you who believe! Eat
not your property among yourselves unjustly by falsehood and deception, except it be a trade
amongst you, by mutual consent” (Surah Al-Nisa, 29).
3. Prohibition of maysirIt means games of pure chance where any party might gain at the expense of the loss of the other
party. “O believers, wine and gambling, idols and divination by arrows are but abominations
devised by satan; avoid them so that you may prosper.
Indeed satan seeks to stir up enmity and hatred among you by means of wine and gambling and to
keep you away from remembrance of Allah (S.w.t.) and from your prayers” (Surah al-Ma’idah,
90-91).
Mutuality of risk sharing:
The Qur’an had permitted sale due to fairness in risk and return that assumes risk-taking where the
seller deserves the profit from the sale. Risk can be divided into the following three types:
I.
II.
III.
Entrepreneurial risk that might occur as part of the normal course of business in every
economic activity.
Natural risk that might occur from natural disasters and calamities that can be minimized
through cooperative insurance.
Unnecessary risk which are not part of everyday life but arise from games of chance created
by people.
Governance and transparency:
The significance of shari’ah governance transpires via its role of ensuring the confidence of the
islamic finance industry in the eyes of the public. More importantly, shari’ah governance ensures
that the industry is at all times in accordance with the wishes and laws of the Almighty by ensuring
the legitimacy of the products offered.
Effective shari’ah governance requires the setting up of a clear and comprehensive framework to
regulate the islamic finance industry and guide its development by forming shari’ah advisors. IFIs
must abide and adhere to the same regulatory requirements when it comes to the issue of
disclosures that will ensure the smooth management.
Issues and challenges (In Empowering Shariah in Islamic Finance):
1. Ensuring the maximum utilization of the shari’ah principles in developing islamic financial
products.
2. Addressing the need for harmonisation of the interpretation of shari’ah across jurisdictions.
3. Ensuring a high quality and standard of shari’ah services.
4. Realising maqasid al-shari’ah at the level of general framework of islamic finance or
product development.