Islamic Finance and Banking

Prepared By:
Dr. H. M. Mosarof Hossain
Professor
Department of Finance
University of Dhaka
mosarof@du.ac.bd

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Chapter 1 : Introduction to Islamic Financial System

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. shariah.
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 2
Chapter 1 : Introduction to Islamic Financial System

Why study islamic finance?

principles underlined by shariah 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:

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Chapter 1 : Introduction to Islamic Financial System

i. understand the importance of religion and

economic factors in Islamic finance and banking.
ii. define the concepts underlying Islamic finance and
banking.
iii. define the concept of unpleasant practices and
identify its components.
iv. discuss the legal maxims and main underlying
Islamic principles related to Islamic financing
instruments which are Shariah compliant.
v. identify the structure of a modern Islamic financial
system.
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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 behavior 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 shariah
that is the bedrock of the worldview of islam.
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 What exactly is shariah?
Sharia or sharia law (Arabic: )is 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 shar 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).
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 What exactly is shariah?
When applied to finance, much of these laws,
rules and interpretations of the shariah 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 shariah
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 shariah also
known as maqasid al-shariah.

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 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:
Tawhid-Gods unity
Rububiyyah-divine arrangements of things perfectly
Risalah-prophethood and guidance
Akhirah-belief in accountability on the day of judgement
Istikhlaf-mans role as Gods vicegerent on earth
Tazkiyah- purification
Kafalah-social solidarity
Adalah-justice
Falah-success in this world and hereafter
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 Reasons for Riba Prohibition

1. Riba corrupts society (Surah ar-Rum 37-41)

2. Riba implies improper appropriation of others
property (Surah an-Nisa 160-161)
3. Ribas ultimate effect is negative growth (Surah al-
Baqarah 276)
4. Riba demeans and diminishes human personality
(Surah al-Baqarah 275)
5. Riba is unjust (Surah al-Baqarah 279)

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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:

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Functions Islamic financial system
i. Bringing together surplus fund units to deficit
fund units through shariah compliant
manner.
ii. Channelling of investable funds from
surplus-income units to deficit income units.
iii. Mobilising large amounts of relatively small
savings and pool them together to channel
them for productive investments in the
economy.

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 Types of Islamic financial markets

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.

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 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-murib
udrib; 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
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 Islamic financial intermediaries

caravan trades were financed by murabah (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.

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 Types of Islamic financial intermediaries

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

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 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 shariah but at the same time, enables it to
work effectively and efficiently. The followings are some
essential requirements for a successful islamic financial
system:
i. Strong risk management practice
ii. Effective regulation
iii. Sound corporate and shariah governance
iv. A supportive legal framework
v. Robust accounting disclosure and taxation regime.

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 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.
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Principles and development of Islamic finance
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 dont 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.

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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, Citibanketc.) have setups
separate windows to offer Islamic banking services.

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 Development and growth of Islamic finance
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.

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 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 doesnt 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
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.

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 Basic contracts & instruments

c) 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
Vehicles for capital instrument in the form of a partnership.
a) Mudarabah
A fund management instrument , could be short, medium or long term, whereby
an investor entrust capital to an agent to undertake a project.
b) 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.

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 Basic contracts & instruments

III. 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
1) Islamic banks
Could be public or private sector.
A hybrid of conventional commercial banks & investment banks, it
resembles universal banks.
2) Islamic windows
A setup in a conventional bank that offer Shariah-compliant product.

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 Basic contracts & instruments

3) Islamic investment banks & funds

Aiming to capitalize on large investment syndications, market-making
and under writing opportunities.
Succeeded in developing innovative large-scale transactions in
infrastructure finance.
4) Islamic mortgage companies
Targeted at the housing market for Muslim communities in western
countries.
Four models:
1. Ijarah.
2. Equity partnership (diminishing Musharaka).
3. Murabahah (sales transaction).
4. Lines of corporative societies.

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 Basic contracts & instruments

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.

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 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.
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 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.

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 Areas of improvement & steps forward
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.

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 Areas of improvement & steps forward
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.

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