Islamic Finance

Chapter One: Overview of Islamic Finance &

Banking

McGraw-Hill/Irwin Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.
1. Overview
• Islamic banking refers to a system of banking activity that is
consistent with the principles of Islamic law (Sharia’a) and
its practical application through the development of Islamic
economics.
• Sharia’a prohibits the payment or acceptance of interest for
the lending and accepting of money respectively (Riba,
Usury) for specific terms, as well as investing in businesses
that provide goods or services considered contrary to its
principles (Haram, Forbidden).
• Although these principles were used as the basis for a
flourishing economy in earlier times, only in the late 20th
century were a number of Islamic banks formed to apply
these principles to private or semi-private commercial
institutions.
13-2
2. Riba
• The word ‘‘Riba’’ means excess, increase or
addition, which according to Sharia’a
terminology, implies any excess
compensation without due consideration.
Consideration does not include the time value
of money.
• The definition of Riba in classical Islamic
jurisprudence was ‘‘surplus value without
counterpart’’.

13-3
 3. History of Islamic Banking
• During the Islamic Golden Age, early forms of proto-capitalism
and free markets were present in the Caliphate era, where an
early market economy and an early form of mercantilism were
developed between the 8th–12th centuries, which some refer
to as ‘Islamic capitalism’.
• A number of economic concepts and techniques were applied
in early Islamic banking,
• include bills of exchange, the first forms of partnership
(Mufawada), limited partnerships (Mudaraba), and the earliest
forms of capital (Al-mal), capital accumulation (Nama al-mal),
• cheques, promissory notes, trusts (Waqf ), transactional
accounts, ledgers and assignments.

13-4
4. Modern Islamic Banking
• The first modern experiment with Islamic banking was
undertaken in Egypt without projecting an Islamic image –
for fear of being seen as a manifestation of Islamic
fundamentalism(anathema to the political regime). The
pioneering effort, led by Ahmad El Naggar, took the form
of a savings bank based on profit-sharing in the Egyptian
town of Mit Ghamr in 1963. This experiment lasted until
1967.
• In 1972, the Mit Ghamr Savings project became part of
Nasr Social Bank which, currently, is still in business in
Egypt. The first modern commercial Islamic bank, Dubai
Islamic Bank, opened its doors in 1975. In the early years,
the products offered were basic and strongly founded on
conventional banking products.
13-5
 5. Islamic Finance Principle
• The basic principle of Islamic banking is the sharing of profit
and loss and the prohibition of riba (usury).
• Common terms used in Islamic banking include profit
sharing
(Mudaraba), safekeeping (Wadiah), joint venture (Musharaka),
cost plus (Murabaha) and leasing (Ijara).

13-6
6. Islamic Finance Modes and instruments(ex)

• 6/1 Murabaha
• In an Islamic mortgage transaction, instead of loaning the buyer
money to purchase the item,
• a bank might buy the item itself from the seller, and re-sell it to the
buyer at a profit, while allowing the buyer to pay the bank in
instalments. In order to protect itself against default, the bank asks for
collateral.
• The goods or land is registered to the name of the buyer from the
start of the transaction.

13-7
6. Islamic Finance Modes and instruments

• 6/2 Musharaka

• An innovative approach applied by some banks for home

loans.
• The bank and borrower form a partnership entity, both
providing capital at an agreed percentage to purchase the
property.
• The partnership entity then rents out the property to the
borrower and charges rent. The bank and the borrower
then share the proceeds from this rent based on the
current equity share of the partnership.

13-8
6. Islamic Finance Modes and instruments
• 6/3 Mudaraba

• is venture capital funding of an entrepreneur who provides

labour while financing is provided by the bank so that both
profit and risk are shared. Such participatory
arrangements between capital and labour reflect the
Islamic view that the borrower must not bear all the
risk/cost of a failure, resulting in a balanced distribution of
income.

13-9
7. Islamic Finance restrictions
• Islamic banking activities is restricted to
Islamically acceptable transactions, which exclude
those involving alcohol, pork, gambling and so on.
The aim of this is to engage in only ethical
investing, and moral purchasing. Islamic banks
have grown recently in the Muslim world but
remain a very small share of the global banking
system.

13-10
8. Islamic Finance Principles
• Six key principles drive the activities of Islamic banks:
• 1-predetermined loan repayments as interest (Riba) is
prohibited;
• 2-profit and loss sharing is at the heart of the Islamic
system;
• 3-making money out of money is unacceptable: all
financial transactions must be asset-backed;
• 4-speculative behaviour is prohibited;

• 5-only Sharia’a-approved contracts are acceptable;

• 6- contracts are sacred.

13-11
8.1. Predetermined Payments are Prohibited
• Any predetermined payment over and above the actual amount of
principal is prohibited. Islam allows only one kind of loan and that is
qard al hassan (literally meaning good loan), whereby the lender does
not charge any interest or additional amount over the money lent.
Traditional Muslim Jurists have construed this principle so strictly that,
according to one Islamic scholar the prohibition applies to any
advantage or benefits that the lender might secure out of the qard
(loan) such as riding the borrower’s mule, eating at his table or even
taking advantage of the shade of his wall.
• The principle, derived from this quotation, emphasises that any
associated or indirect benefits that could potentially accrue to the
lender, from lending money, are also prohibited.

13-12
8.2. Profit and Loss Sharing
• The principle here is that the lender must share in the
profits or losses arising out of the enterprise for which the
money was lent. Islam encourages Muslims to invest their
money and to become partners in order to share profits
and risks in a business instead of becoming creditors.
• The central principle is that under any Islamic financing
arrangement the financier is only entitled to returns if risk
is involved. If a return is expected there must be risk. If
there is no relationship between risk and return, then this
financial arrangement is not permitted Islamically. It is this
lack of risk, which takes place with allowing Riba, that
makes interest so anathema to Muslims.

13-13
8.3. Making Money Out of Money is Not Acceptable
• Making money from money is not Islamically acceptable. Money, in
Islam, is only a medium of exchange, a way of defining the value of a
thing. It has no value in itself, and therefore should not be allowed to
generate more money, via fixed interest payments, simply by being
deposited in a bank or lent to someone else.
• Muslims are encouraged to spend and/or invest in productive
investments and are discouraged from keeping money idle. Hoarding
money is regarded as being Islamically unacceptable.
• In Islam, money represents purchasing power, which is considered to
be the only proper use of money. This purchasing power (money)
cannot be used to make more purchasing power (money) without
undergoing the intermediate step of it being used for the creation of
goods and services.

13-14
8.4. Uncertainty is Prohibited
• Gharar (uncertainty, risk or speculation) is also prohibited, and so any
transaction entered into should be free from these elements.
Contracting parties should have perfect knowledge of the counter-
values intended to be exchanged as a result of their transactions.
• In this context the term counter-values is used in the sense of
something being deferred, either the price paid or the commodity
delivered. Deferral of payment is an acceptable form of debt under
Islam, in contrast to predetermined debt in conventional finance.
• Also, parties cannot predetermine a guaranteed profit. The rationale
behind the prohibition of gharar is the wish to protect the weak from
exploitation.

13-15
8.5. Only Sharia’a-Approved Contracts are
Acceptable
• Conventional banking is secular in its orientation.
In contrast, in the Islamic system, all economic
agents have to work within the ethical system of
Islam. Islamic banks are no exception.
• As such, they cannot finance any project that
conflicts with the Islamic moral value system. For
example Islamic banks are not allowed to finance
a wine factory, a casino, a night club or any other
activity prohibited by Islam or known to be
harmful to society.

13-16
8.6. Sanctity of Contract

• Many verses in the Holy Qur’an encourage trade and

commerce, and the attitude of Islam is that there should
be no impediment to honest and legitimate trade and
business. It is a duty for Muslims to earn a living, support
their families and give charity to those less fortunate.
• Just as Islam regulates and influences all other spheres of
life, so it also governs the conduct of business and
commerce. Muslims have a moral obligation to conduct
their business activities in accordance with the
requirements of their religion. They should be fair, honest
and just towards others. A special obligation exists upon
vendors because there is no doctrine of caveat emptor in
Islam. Monopolies and price-fixing are prohibited.
13-17
Thank you

13-18