Economic and Financial system; Conventional and Islamic Financial System,

Financial markets and Islamic applications; Financial System of Bangladesh

By
Basharat Hossain
Assistant professor of Economics
Department of Business Administration (DBA)
International Islamic University Chittagong (IIUC)
Bangladesh

Economic and Financial system Conventional and Islamic, Financial markets

and Islamic applications

Economic system: An economic system is a collection of institutions set up by society to deal

with the allocation of resources, production and goods and services, and the distribution of the
resulting income and wealth.
Islamic Economic system: A collection of institutions (that is, formal and informal rules of
conduct and their enforcement characteristics) designed by the Law-Giver (that is, Allah (swt)
through the rules prescribed in the Qur’an, operationalized by the sunnah of the Prophet (pbuh)
and extended to new situations by ijtihad) to deal with allocation of scarce resources, production
and the exchange of goods and services and the distribution of the resulting income and wealth.

Types of economy:

1. Market/Capitalist Economy: is one in which individuals and private firms make the
major decision about allocation of resources, production, distribution and consumption.
This is an economy that allocates resources through the decentralized decisions of many
firms and households as they interact in markets for goods and services. Example-UK
(came to close in 18th century).

2. Laissez – faire economy: the extreme case of a market economy, in which Governments

keeps its hands off economic decisions, is called a Laissez – faire economy.

Prepared by - Basharat Hossain, Assistant Professor of Economics, Dept. of Business Administration,

International Islamic University Chittagong, Bangladesh
Page 1
 3. Command/Planned/Centralized/Communist/Socialist Economy: is one in which the
government makes all important decisions about allocation of resources, production,
distribution and consumption. Example-ex-soviet union, China, Cuba, Venezuela

4. Islamic Economy: the economy which runs according to the law of welfare, justice and
Islamic Shariah. Example-Medina state in 7th century, Iran (came to close).

5. Mixed Economy: it includes the elements of market, command and Islamic economy.
Example-almost all economy of the world, Bangladesh, India etc.

Comparative analysis of different doctrines:

Figure-1: Economic Doctrines of life

Capitalism Communism Islam

Worldly life & confused worldly life is the only life & Worldly life & Hereafter life
about Hereafter life no Hereafter life
There is a GOD but forget in There is no GOD or creator ALLAH is the only creator
daily life and God
Self-satisfaction Self-satisfaction through Satisfaction of ALLAH
state intervention
Self-interest &Rationalism is Rationalism and state is the Individualism &Rationalism
the sole authority of decision sole authority of decision through moral filtering is a
making making part of decision making
Competitive market: survival State control the market Combination of competition
for the fittest and state intervention:
Humanity & Philanthropy
No value judgment No value judgment Value judgment, social,
national, cultural values
Independent of revealed No religion Religion is key determinant
religion, Religion is
unreliable
Earning at any way Earning at any way Earning at honest way
Economic Laws are like Economic Laws are like Economic laws are like
physical laws physical laws natural laws
Economics is a positive Economics is a positive Economics is value oriented.
science as like as biology, science as like as biology, Permissible & prohibition
physics which have no value, physics which have no value, have to be observed
value neutral value neutral
Little concern for poor Theoretically, concern for Major concern for poor.

Prepared by - Basharat Hossain, Assistant Professor of Economics, Dept. of Business Administration,

International Islamic University Chittagong, Bangladesh
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 humanity poor humanity but not Poverty alleviation by Zakat,
practically Sadaqa & gives emphasis on
economic progress

Figure-2: Stages of life and difference in Visions of two consumers (Schematic chart)

Islamic man Conventional man

Born (coming from Heavenly life) Born (Natural Law of human life)
↕ ↕
Education life (worldly+ Religious) Education life (worldly)
↕ ↕
Working/professional life (earning an honest Working/professional life (earning an any way)
way directed by Religion) ↕
↕ Family life (Wealth)
Family life (Religious) ↕
↕ Life Style
Life Style (Luxurious life style)
(Moderate/simple life style) ↕
↕ Worldly life (Enjoy the worldly life-Only place for
Worldly life (Enjoy the worldly life & success & rewards)
Prepare for Hereafter life) ↕
↕ Retired life (reading, travelling, etc.)
Retired life (reading, travelling, Ibadah, etc.) ↕
↕ Death (Natural departure)
Death (start the journey for Hereafter life )

Financial system:

A financial system consists of institutional units and markets that interact, for the purpose of
mobilizing funds for investment and providing facilities, including payment systems, for the
financing of commercial activity.

An institutional unit is an entity, such as a household, corporation, or government agency, that is

capable in its own right of owning assets, incurring liabilities, and engaging in economic
activities and transactions with other entities.

The role of financial institutions within the system is primarily to intermediate between those
that provide funds and those that need funds, and typically involves transforming and managing
risk. Particularly for a deposit taker, this risk arises from its role in maturity transformation,
where liabilities are typically short term (for example, demand deposits), while its assets have a

Prepared by - Basharat Hossain, Assistant Professor of Economics, Dept. of Business Administration,

International Islamic University Chittagong, Bangladesh
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longer maturity and are often illiquid (for example, loans). Financial markets provide a forum
within which financial claims can be traded under established rules of conduct and can facilitate
the management and transformation of risk. They also play an important role in identifying
market prices (“price discovery”).

Importance of Financial system:

The prime objective of any economy is to allocate its scarce natural resources in order to produce
goods and services to maintain the standard of living of the people of the country. But without
ensuring the harmonious development of all the sectors of the economy it is absolutely
impossible to satisfy the unlimited demand of the people for goods and services. Yes, it is really
possible on the proper functioning of a just financial system or discipline. An efficient financial
system thus performs the function of financial intermediation allocating resources in the line
with national priorities at lower cost for the economic development of a country.

Thus, the historical association between financial system and economic growth has been
acknowledged by distinguished scholars and prominent economists.

Prepared by - Basharat Hossain, Assistant Professor of Economics, Dept. of Business Administration,

International Islamic University Chittagong, Bangladesh
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Functions of Financial system:

1. Encourage savings.
2. Accumulates capital.
3. Mobilizes the capital.
4. Allocates the fund in the needed sectors.
5. Supports production
6. Assists economic growth and development.
7. Shapes the total economic system.
8. Act as intermediary between savers and investors.
9. Handles huge volume of government debts.
10. Determines the quantum of speed for growth and development of the society

Role and Scope of Financial system:

The role played by any financial system is enormous and can by systematically explained in the
following paras:

1. Saving function – providing a potentially profitable and relatively low risk outlet for
the savings of the people.
2. Liquidity aspect – providing a means of raising funds by converting securities and
financial assets in the form of cash.
3. Payment technique – providing mechanism for making payments for purchase of
goods and services to meet the needs of the life.
4. Policy determination – providing a channel for Govt. Policy to achieve the goals of
high employment, low inflation, economic growth and stability in the society.
5. Wealth creation – providing means to preserve purchasing power until needed at a
future date for spending on goods and services.
6. Credit supply – providing a continuing supply of credits for business, customers and
government to support both consumption and investment.
7. Risk avoidance – providing means to protect business, consumer and government
against risks to people, property and income.
8. Invest opportunity – providing opportunities for investment of surplus funds in
various profitable as well as risk-stricken sectors of the economy for equitable

Prepared by - Basharat Hossain, Assistant Professor of Economics, Dept. of Business Administration,

International Islamic University Chittagong, Bangladesh
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 mobilization of economic resources and production of essential commodities to
maintain a just living standard of the people of the society etc.

Structure of Financial System: The main constituents of financial system are:

1. Financial Institutions
2. Financial Instruments, and
3. Financial Markets.

1. Financial Institutions

The modern name of Financial Institution is Financial Intermediary (FI), because it mediates or
stands between ultimate borrowers and ultimate lenders and helps transfer funds from one to
another. The Financial system helps production, capital-accumulation and growth by
encouraging savings and allocating them among the alternative uses and users.
Overview of Financial system of Bangladesh 

The financial system of Bangladesh is comprised of three broad fragmented sectors:

1. Formal Sector
2. Semi-Formal Sector
3. Informal Sector

The sectors have been categorized in accordance with their degree of regulation.
1. The formal sector includes all regulated institutions like Banks, Non-Bank Financial
Institutions (FIs), Insurance Companies, Capital Market Intermediaries like Brokerage
Houses, Merchant Banks etc.; Micro Finance Institutions (MFIs). 

2. The semi-formal sector includes those institutions which are regulated otherwise but do

not fall under the jurisdiction of Central Bank, Insurance Authority, Securities and
Exchange Commission or any other enacted financial regulator. This sector is mainly
represented by Specialized Financial Institutions like House Building Finance
Corporation (HBFC), Palli Karma Sahayak Foundation (PKSF), Samabay Bank,
Grameen Bank etc., Non Governmental Organizations (NGOs and discrete government
programs. According to statistics of Bangladesh NGO Bureau, 2356 NGOs are working
in Bangladesh (31th December, 2014)

Prepared by - Basharat Hossain, Assistant Professor of Economics, Dept. of Business Administration,

International Islamic University Chittagong, Bangladesh
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 3. The informal sector includes private intermediaries which are completely unregulated.

1. Formal Sector

A. Banks: After the independence, banking industry in Bangladesh started its journey with 6
nationalized commercialized banks, 2 State owned specialized banks and 3 Foreign
Banks. In the 1980's banking industry achieved significant expansion with the entrance of
private banks. Now, banks in Bangladesh are primarily of two types:

1. Scheduled Banks: The banks which get license to operate under Bank Company Act,
1991 (Amended in 2003) are termed as Scheduled Banks.

2. Non-Scheduled Banks: The banks which are established for special and definite
objective and operate under the acts that are enacted for meeting up those objectives, are
termed as Non-Scheduled Banks. These banks cannot perform all functions of scheduled
banks.

1. Scheduled banks:
There are 56 scheduled banks in Bangladesh who operate under full control and supervision of
Bangladesh Bank which is empowered to do so through Bangladesh Bank Order, 1972 and Bank
Company Act, 1991. Scheduled Banks are classified into following types:
State Owned Commercial Banks (SOCBs): There are 5 SOCBs which are fully or majorly
owned by the Government of Bangladesh.
Specialized Banks (SDBs): 3 specialized banks are now operating which were established for
specific objectives like agricultural or industrial development. These banks are also fully or
majorly owned by the Government of Bangladesh.
Private Commercial Banks (PCBs): There are 39 private commercial banks which are
majorly owned by the private entities. PCBs can be categorized into two groups:
Conventional PCBs: 31 conventional PCBs are now operating in the industry. They perform
the banking functions in conventional fashion i.e interest based operations.

Prepared by - Basharat Hossain, Assistant Professor of Economics, Dept. of Business Administration,

International Islamic University Chittagong, Bangladesh
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Islami Shariah based PCBs: There are 8 Islami Shariah based PCBs in Bangladesh and they
execute banking activities according to Islami Shariah based principles i.e. Profit-Loss Sharing
(PLS) mode.
Foreign Commercial Banks (FCBs): 9 FCBs are operating in Bangladesh as the branches of
the banks which are incorporated in abroad.

2. Non-Scheduled Banks:  There are now 4 non-scheduled banks in Bangladesh which

are:
Ansar VDP Unnayan Bank,
Karmashangosthan Bank,
Probashi Kollyan Bank,
Jubilee Bank
B. Non-Bank Financial Institutions (FIs)
Non-Bank Financial Institutions (FIs) are those types of financial institutions which are
regulated under Financial Institution Act, 1993 and controlled by Bangladesh Bank. Now, 31
FIs are operating in Bangladesh while the maiden one was established in 1981. Out of the
total, 2 is fully government owned, 1 is the subsidiary of a SOCB, 13 were initiated by
private domestic initiative and 15 were initiated by joint venture initiative. Major sources of
funds of FIs are Term Deposit (at least six months tenure), Credit Facility from Banks and
other FIs, Call Money as well as Bond and Securitization.

The major difference between banks and FIs are as follows:

1. FIs cannot issue cheques, pay-orders or demand drafts.
2. FIs cannot receive demand deposits,
3. FIs cannot be involved in foreign exchange financing,
4. FIs can conduct their business operations with diversified financing modes like
syndicated financing, bridge financing, lease financing, securitization instruments, private
placement of equity etc.
List of some Non-Bank Financial Institutions (FIs) in Bangladesh:

    National Finance Ltd

    MIDAS Financing Ltd. (MFL)
    LankaBangla Finance Ltd.
    Islamic Finance and Investment Limited
    Bangladesh Finance & Investment Co. Ltd.
    Agrani SME Finance Co. Ltd.

Prepared by - Basharat Hossain, Assistant Professor of Economics, Dept. of Business Administration,

International Islamic University Chittagong, Bangladesh
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 C. Insurance sector in Bangladesh:
Insurance sector in Bangladesh emerged after independence with 2 nationalized insurance
companies- 1 Life & 1 General; and 1 foreign insurance company. In mid 80s, private sector
insurance companies started to enter in the industry and it got expanded. Now days, 62
companies are operating under Insurance Act 2010. Out of them- 18 are Life Insurance
Companies including 1 foreign company and 1 is state-owned company, 44 General Insurance
Companies including 1 state-owned company. 
Insurance companies in Bangladesh provide following services:
 Life insurance,
 General Insurance,
 Reinsurance,
 Micro-insurance,
 Takaful or Islami insurance

List of some non-life insurance companies

1. Agrani Insurance Company Ltd.

2. Asia Insurance Ltd.
3. Asia Pacific Gen Insurance Co. Ltd.
4. Bangladesh Co-operatives Ins. Ltd.

List of some life insurance companies

1. American Life Insurance Company (Foreign Company)

2. Homeland Life Insurance Company Ltd.
3. Meghna Life Insurance Company Ltd.
4. National Life Insurance Company Ltd.

List of the Insurance Companies in Public Sector

1. Sadharan Bima Corporation(Gen. Ins)

2. Jiban Bima Corporation (Life Ins.)

D. Microfinance Institutions (MFIs):

Prepared by - Basharat Hossain, Assistant Professor of Economics, Dept. of Business Administration,

International Islamic University Chittagong, Bangladesh
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The member-based Microfinance Institutions (MFIs) constitute a rapidly growing segment of the
Rural Financial Market (RFM) in Bangladesh. Microcredit programs (MCP) in Bangladesh are
implemented by various formal financial institutions (nationalized commercial banks and
specialized banks), specialized government organizations and Non-Government Organizations
(NGOs). The growth in the MFI sector, in terms of the number of MFI as well as total
membership, was phenomenal during the 1990s and continues till today.

Despite the fact that more than a thousand of institutions are operating microcredit programs, but
only 10 large Microcredit Institutions (MFIs) and Grameen Bank represent 87% of total savings
of the sector and 81% of total outstanding loan of the sector. Through the financial services of
microcredit, the poor people are engaging themselves in various income generating activities and
around 30 million poor people are directly benefited from microcredit programs. 

Credit services of this sector can be categorized into six broad groups: i) general microcredit for
small-scale self-employment based activities, ii) microenterprise loans, iii) loans for ultra poor,
iv) agricultural loans, v) seasonal loans, and vi) loans for disaster management.
Currently, 697 institutions (2015) have been licensed by MRA to operate Micro Credit
Programs. But, Grameen Bank is out of the jurisdiction of MRA as it is operated under a distinct
legislation- Grameen Bank Ordinance, 1983.

2. Financial market:
Financial market in Bangladesh: The financial market in Bangladesh is mainly of following
types:
1. Money Market: The primary money market is comprised of banks, FIs and primary
dealers as intermediaries and savings & lending instruments, treasury bills as instruments.
There are currently 15 primary dealers (12 banks and 3 FIs) in Bangladesh. The only
active secondary market is overnight call money market which is participated by the
scheduled banks and FIs. The money market in Bangladesh is regulated by Bangladesh
Bank (BB), the Central Bank of Bangladesh.

2. Capital market: The primary segment of capital market is operated through private and
public offering of equity and bond instruments. The secondary segment of capital market
is institutionalized by two (02) stock exchanges-Dhaka Stock Exchange and Chittagong
Stock Exchange. The instruments in these exchanges are equity securities (shares),
debentures, corporate bonds and treasury bonds. The capital market in Bangladesh is
governed by Securities and Commission (SEC).
Prepared by - Basharat Hossain, Assistant Professor of Economics, Dept. of Business Administration,
International Islamic University Chittagong, Bangladesh
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 3. Foreign Exchange Market: Towards liberalization of foreign exchange transactions, a
number of measures were adopted since 1990s. Bangladeshi currency, the taka, was
declared convertible on current account transactions (as on 24 March 1994), in terms of
Article VIII of IMF Article of Agreement (1994). As Taka is not convertible in capital
account, resident owned capital is not freely transferable abroad. Repatriation of profits
or disinvestment proceeds on non-resident FDI and portfolio investment inflows are
permitted freely. Direct investments of non-residents in the industrial sector and portfolio
investments of non-residents through stock exchanges are repatriable abroad, as also are
capital gains and profits/dividends thereon. Investment abroad of resident-owned capital
is subject to prior Bangladesh Bank approval, which is allowed only sparingly.

Bangladesh adopted Floating Exchange Rate regime since 31 May 2003. Under the
regime, BB does not interfere in the determination of exchange rate, but operates the
monetary policy prudently for minimizing extreme swings in exchange rate to avoid
adverse repercussion on the domestic economy. The exchange rate is being determined in
the market on the basis of market demand and supply forces of the respective currencies.

In the forex market, banks are free to buy and sale foreign currency in the spot and also in
the forward markets. However, to avoid any unusual volatility in the exchange rate,
Bangladesh Bank, the regulator of foreign exchange market remains vigilant over the
developments in the foreign exchange market and intervenes by buying and selling
foreign currencies whenever it deems necessary to maintain stability in the foreign
exchange market.

3. Financial instruments:
Money Market Instruments: Money market claim mature in less than one year. Because of
their short-term maturity, money market instruments undergo the least price fluctuations and so
are the risky investments.

The common types of money market securities traded in Bangladesh are given below:

1. Treasury Bills (T-Bills).

2. Repurchase Agreements ( Repo or Reverse Repo)
3. Commercial Papers
4. Certificate of Deposit
Prepared by - Basharat Hossain, Assistant Professor of Economics, Dept. of Business Administration,
International Islamic University Chittagong, Bangladesh
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 5. Banker's Acceptance
6. Call money
Money market participants

Banks, Non-bank, Financial Institutions (takaful companies), business corporations, government

and central bank

Capital market instruments:

Debt and equity instruments wit maturity of over one year called capital market instruments.
They have far wider price fluctuations than money market instruments and are considered to
fairly risky instruments.

1. Common stocks/Equity
2. Bonds
3. Mortgages
4. Futures
5. Options

Difference between money market and capital market:

Money Market Capital Market

Definition Is a component of the financial markets where Is a component of financial markets

short-term borrowing takes place where long-term borrowing takes place

Maturity Period Lasts anywhere from 1 hour to 90 days. Lasts for more than one year and can
also include life-time of a company.

Credit Instruments Certificate of deposit, Repurchase agreements, Stocks, Shares, Debentures, bonds,
Commercial paper, Eurodollar deposit, Federal Securities of the Government.
funds, Municipal notes, Treasury bills, Money
funds, Foreign Exchange Swaps, short-lived
mortgage and asset-backed securities.

Nature of Credit Homogenous. A lot of variety causes problems for Heterogeneous. A lot of varieties are
Instruments investors. required.

Purpose of Loan Short-term credit required for small investments. Long-term credit required to establish
business, expand business or purchase
fixed assets.

Prepared by - Basharat Hossain, Assistant Professor of Economics, Dept. of Business Administration,

International Islamic University Chittagong, Bangladesh
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Basic Role Liquidity adjustment Putting capital to work

Institutions Central banks, Commercial banks, Acceptance Stock exchanges, Commercial banks and
houses, Nonbank financial institutions, Bill Nonbank institutions, such as Insurance
brokers, etc. Companies, Mortgage Banks, Building
Societies, etc.

Risk Risk is small Risk is greater

Market Regulation Commercial banks are closely regulated to Institutions are regulated to keep them
prevent occurrence of a liquidity crisis. from defrauding customers.

Relation with Closely related to the central banks of the country. Indirectly related with central banks and
Central Bank feels fluctuations depending on the
policies of central banks.
 
The goals/ Objectives of Islamic Economic system:

1. Establishment of Adl (justice), to attain Hasanah (good) and Falah (welfare) in this life
and the life hereafter.
2. To establish Ihsan (gracious conduct or kindness) in economic affairs
3. Establishment of Maroof (proper or good acts, institutions) in economic life.
4. Elimination of Munker (evil, wrong or injurious practices) form economic life.
5. Freeing humanity from unwanted burdens and shackles and to make life easier for them
6. Achieve maximum economic growth.
7. Maximize employment to ensure maximum distribution of wealth in society.
8. Encourage co-operation in society
9. Favouring weaker sections to establish them in life

Basic Characteristics of Islamic Economic system:

Freedom of work and enterprises: Islam has allowed freedom of work and enterprise. This is
evident from the Madinite model of Islamic economy. A reading of the chapter of any Hadith
collection in respect of agriculture, gardening, business etc. will establish this. The Quran also
clearly states that “Allah has made business lawful for you (Sura Baqara)”.

Free Economy: Islam allows economy to operate freely according to the market for us, subject
to Islamic restrictions and guidelines on production, distribution, marketing, investment, trade,
exchange, wages etc. The state can also further interfere in this free economy to restore
equilibrium and establish justice and other Islamic objectives as explained above. In an Islamic
Prepared by - Basharat Hossain, Assistant Professor of Economics, Dept. of Business Administration,
International Islamic University Chittagong, Bangladesh
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economy, there is an “allow ability constraint” in every field (a term introduced by Dr. SNH
Naqvi in his above mentioned book). An entrepreneur can produce only permitted things.
Projects should be normal in such an economy, after giving proper wages to the labourers in
accordance with Islamic principles. Some forms of trade practices, exchange, investment and
land tenancy in agriculture arte prohibited in Islam. It also disallows monopoly and hoarding as
social evils.

The aforesaid restrictions make “Free economy in Islam qualitatively different from capitalism.
Islam cannot be said to be capitalistic only because it allows forces of demand and supply to
operate in the economy. Forces of demand and supply are fundamental economic forces, which
were operational in all ages even before capitalism.

Trusteeship ownership: In Islam God is the true owner of all things. The Quran says: “ To
Allah belongs whatever is in the heavens and whatsoever is in the earth”.

Protection of lawful property: Islam protects lawful property and is in favour of confiscation of
unlawful property. There are many instances of take-over of unlawful property during the period
of Hazrat Omar and Hazrat Omar bin-Abdul Aziz. Lawful property can be taken over by the
state only for valid social seasons after due compensation. During the last Hajj, the Prophet (S.
M.) announced the principle of protection of lawful property. The Quran says, “Don’t eat each
other’s property wrongly”. (Sura Nisa: Ayat 29).

Prohibition of interest: Islam prohibits interest. This requires a total reorganization of the
economy, banking, investment, exchange, business and international trade. A big effort is under
way in the Muslim world in this direction. A body of literature has already come up on this
subject.

Zakat: Islam has made Zakat compulsory on the wealth of rich Muslims. This is spent for the
weaker and distressed sections of the society. Zakat not only distributes wealth between the rich
and poor of the society, it also influences investment, savings and allocation of income and
resources. A detailed study has been made in this regard by Dr. Monzer Kahf in his book “
Islamic Economy”. American Trust Publications, U.S. A. A rich body of literature has come up
in recent times on Zakat. The Zakat and Ushr Ordinance of Pakistan can be particularly referred
to in this connection.

Concern for poor: This is a special feature of Islam . Zakat is one institution which testifies to
this. In this connection we may refer to Ayat 5-6 Sura Qausar as quoted in para 6 above, is
particularly significant, where Allah, the Almighty has expressed this desire to show favour on

Prepared by - Basharat Hossain, Assistant Professor of Economics, Dept. of Business Administration,

International Islamic University Chittagong, Bangladesh
Page 14
the depressed people. Islamic economy shall establish all possible institutions to carry out this
desire of the Almighty.

Distribution of inheritance: Islam has not left the distribution of inheritence on the whims of a
person. In Islam a person cannot favour one over the other of his relations for temporary or
subjective reasons as is the rule in the West. Islam distributes inheritable property among several
groups of people: Children, Husband/Wife, Parents, Brothers and sisters in certain situations.

Islamic Financial system:

1. A financial system that is based on Islamic principles and values, which eliminates Riba
and ensure a profit sharing mechanism in the financial system, may be called IFS.
2. It may be characterized by the absence' of interest based financial institution &
transactions, doubtful transactions or Gharar, Stocks of companies dealing in unlawful
activities, unethical or immoral transactions such as market manipulation, insider trading
short-selling etc.

Principles/features of an Islamic financial system/ The requirements to be fulfilled for

successful implementation of Islamic Financial System/:

The basic framework for an Islamic financial system is a set of rules and laws, collectively
referred to as Shariah, governing economic, social, political and cultural aspects of Islamic
societies. Shariah originates from the rules dictated by the Quran and its practices, and
explanations rendered (more commonly known as Sunnah) by the Prophet Muhammad. Further
elaboration of the rules is provided by scholars in Islamic jurisprudence within the framework of
the Quran and Sunnah. The basic principles of an Islamic financial system can be summarized as
follows:

1. Prohibition of interest: Prohibition of Riba, a term literally meaning "an excess" and
interpreted as "any unjustifiable increase of capital whether in loans or sales" is the
central tenet of the system. More precisely, any positive, fixed, predetermined rate tied to
the maturity and the amount of principal (i.e.) guaranteed regardless of the performance
of the investment) is considered Riba and is prohibited. The general consensus among
Islamic scholars is that Riba covers not only usury but also the charging of "interest" as
widely practiced.

Prepared by - Basharat Hossain, Assistant Professor of Economics, Dept. of Business Administration,

International Islamic University Chittagong, Bangladesh
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 2. This prohibition is based on arguments of social justice, equality, and property rights.
Islam encourages the earning of profits but forbids the charging of interest because
profits, determined ex post, symbolize successful entrepreneurship and creation of
additional wealth whereas interest, determined ex ante, is a cost that is accrued
irrespective off the outcome of business operations and may not create wealth if there are
business losses. Social justice demands that borrowers and lenders share rewards s well
as losses in an equitable fashion and that the process of wealth accumulation and
distribution in the economy be fair and representative of true productivity.

3. Risk sharing: Because interest is prohibited, suppliers of funds become investors instead
of creditors. The provider of financial capital and the entrepreneur share business risks in
return for shares of the profits.

4. Money as "Potential" Capital: Money is treated as "Potential" capital -that is, it

becomes actual capital only when it joins hands with other resources to undertake a
productive activity. Islam recognizes the time value of money, but only when it acts as
capital, not when it is "Potential" capital.

5. Prohibition of speculative behavior: An Islamic financial system discourages hoarding

and prohibits transactions featuring extreme uncertainties, gambling, and risks

6. Sanctity of contracts: Islam upholds contractual obligations and the disclosure of

information as a sacred duty. This feature is intended to reduce the risk of asymmetric
information and moral hazard.

7. Shariah approved activities: Only those business activities that do not violate the rules
of Shariah qualify for investment. For example, any investment in businesses dealing
with alcohol, gambling, and casinos would be prohibited.

Structure of a Islamic Financial System based on Shari’ah.

Shariah: The rules of Islam that can never be changed.

Example: Five times prayer in a day is obligatory, Interest is haram, lying, stealing, and cheating
and fraud behaviour is haram in Islam.

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International Islamic University Chittagong, Bangladesh
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Quran: is the revealed and divine book, conveyed to Prophet Muhammad (PBUH) by Jibrael
(A.S) from the almighty ALLAH during 23 years. It is unchangeable and beyond of error. It
includes social and economic rules for the humanity.

Hadith: is the speech, deeds and consent of Prophet Muhammad (PBUH) in his life. It is the
practical explanation of all rules of islam.

Ijma is the Consensus of Islamic scholars on the issues regarding which no specific solution are
not found in the holy Quran and Hadith.

Example: cigarette is prohibited in Islam, interest based credit card is haram

Qiyas is the analytical reasoning of the learned with regard to the teaching of the holy Quran ,
Hadith and Ijma.

Example: Hazrat Omar (R.) has stopped the distribution of acquired land among the
participants/soldires of the war.

Structure of a financial system based on Shari’ah.

Quran Hadith Ijma Qiyas

Basic Rules and Principles of

Islamic Financial System

Shariah Shariah
Compliant Advisory
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product committee
International Islamic University Chittagong, Bangladesh
Page 17
 Islamic Financial Market

Differences between CFS & IFS:

The conventional financial system consists of Socialistic financial system and Capitalistic
financial system. Both systems have been proved inefficient to establish economic balance in the
society.

Basis of Difference CFS IFS

Religious Belief Secular & separates Religion from Belief in unity of God & relates this
other Parts human life belief to economic Life of a man
Freedom of In socialism govt. enjoys Restrictive freedom is allowed in the light
Economic economic freedom but in of Shariah both by the govt. &/or
Activity capitalism Individuals enjoys individuals
freedom.
Ownership of means Socialism-state ownership, Allah is the exclusive owner. Man is the
Capitalism-individual ownership caretaker of the property

Goals of financial Socialism-profit of the society Welfare of both here and hereafter.
System Capitalism-Individual’s profit

Competition Socialism-No competition Logical Competition and financial co-

Capitalism- Logical & unethical operation
competition
Wealth distribution Socialism-Equal Equitable
Capitalism – Unequal
Basis of Economic Riba or Interest Interest Free; PLS, Zakat & Compensation
System based
Sources of the Intellects brain storming of the Devine book “Al-Quran” & Prophets(SM)
System economic problems of men’s life speeches
Result Capitalism concentration of income Maximum & equitable Distribution of
& economic power in few hands. economic opportunities and higher
Inefficiency production in the society

Prepared by - Basharat Hossain, Assistant Professor of Economics, Dept. of Business Administration,

International Islamic University Chittagong, Bangladesh
Page 18
Social & Do not consider the social & Ensure social & environmental welfare
environmental environmental welfare
welfare
Owners exception in Dividend or part of profit in case of Part of Profit or Loss
respect of respect of equity financing
investment
Lender or Bank’s Interest Profit or Loss Sharing
expectation in terms
of dept financing
Modes of Investment Loan, Overdraft & Cash Credit Mudarabah, Musharaka, Murabaha etc.
Need for Islamic Money Market

Islamic bank also faced also exposed to liquidity risk. Like conventional, Islamic bank hold
illiquid assets while liability relatively liquid. Bank with surplus funds can either lend by placing
deposit system with other banks in interbank deposit system or lend by purchasing money market
instruments.

Different between Islamic and Conventional Money Market

Criteria Conventional Islamic

1) Interbank Market Issues debt contract for placement Apply Shariah contracts i.e mudharabah,
of fund murabahah and wakalah
2) Instruments Approved by respective Approved by Shariah Committee and respective
Issuance process regulators regulators.
Structure Structured based on debt only Structure based on assets, equity and debt based.
Investors Conventional investors only. Conventional and Islamic investors.

Islamic Money market instruments: Malaysia:

Central Bank of Malaysia established the Islamic money market in 1994 to cater to the needs of
the Islamic Banks by managing its excess and deficits funds in short term investments. The
Mudharabah Interbank Investment (MIl) was the first instrument introduced. The number of
instruments developed increased from year to year to include a single or multiple Islamic
contracts from mudharabah (profit and loss sharing), musyarakah (partnership), murabahah
(mark up cost), bay bithaman ajil (deferred payment sale), bay ad dayn (sale of debt), and bay al
inah (instantaneous sale and purchase).
1. Mudharabah Interbank Investment
Prepared by - Basharat Hossain, Assistant Professor of Economics, Dept. of Business Administration,
International Islamic University Chittagong, Bangladesh
Page 19
MIl refers to a mechanism whereby a deficit Islamic banking institution (investee bank) can
obtain monies from a surplus Islamic banking institution (investor bank) based on the
Mudharabah (profit sharing) concept. The rate of return is based on the rate of gross profit
before distribution for investment of I-year of the investee bank. The profit rate is unknown
and not predetermined as in interest-based money markets. Only the profit sharing ratio not the
profit rate will be predetermined by the surplus and deficit banks. The principal
invested shall be repaid at the end of the period, together with a share of the profit
arising from use of the funds by the investee bank (I1MM). The process of MIl is
illustrated below:
Banks with excess reserves can invest their excess in the interbank money market
and deficit banks may capitalize on this surplus using the mudharabah concept. In
this case, surplus banks will be the rabbu mal and deficit banks will be the
entrepreneurs. The profit sharing ratio between the rabbu mal and the entrepreneur
will be determined and, for example, a ratio of 70:30. The rabbu mal or the surplus
bank will receive 70% profit while the deficit banks will receive 30%. Another way
to derive the profit and loss sharing ratio for the rabbu mal is by dividing the
rabbu mal expected return by the entrepreneur expected return. The profit-
sharing ratio for the entrepreneur is the difference. The calculation of the profit is as
follows:

Principal = 1,000,000, profit rate: 6%, time: 3 days and profit sharing ratio: 70:30

1.000.000 X 6 % X 3 X 0.7
Profit to surplus bank: =¿345.21
365 X 100

1.000.000 X 6 % X 3 X 0.3
Profit to deficit bank: =¿147.95
365 X 100

2. Islamic Interbank Cheque Clearing System (Iiccs)

Islamic Interbank Cheque Clearing System is a cheque settlement system for

cheque deposits and withdrawals between Islamic commercial banks. The central bank
of Malaysia is the intermediary in settling the net differences between the banks. The
money market instruments are created when participating banks are in deficit or surplus.
The surplus will be invested by the central bank to the deficit banks. For example,
let's assume there are only two banks in Malaysia. If bank A's customer Y pays a
customer Z from Bank B with a cheque for RM100,000 for the purchase of a car, the
accounting treatment for the above transaction is as follows:
In Bank A account:
Prepared by - Basharat Hossain, Assistant Professor of Economics, Dept. of Business Administration,
International Islamic University Chittagong, Bangladesh
Page 20
Debit customer Y: RM100,000
Credit Bank A account at IICCS: RM100,000

And
In Bank B account:

Debit Bank A account at IICCS: RM100,000

Credit customer Z: RM100,000

Now, the total amount for Bank A in I1CCS is RM-100,000 and Bank B is RM100,000
due to the above transaction assuming that there are no prior deposits and the bank
maintains a zero balance. Normally t h e bank will keep some balance with the central
bank using al Wadiah yad Dharnanah. The central bank will transfer the
RM100,000 to Bank A to finance its deficit by using a mudharabah contract. The
formula f o r profit calculation is

Principal X Profit Rate X Time X Profit Sharing Ratio

Profit Formula=
365 X 100

The above process is almost the same as MIl as mentioned earlier in this paper

3. Sale And Buy Back Agreement

Sale and Buy Back Assets (SBBA) is a replication of the repurchase agreements (repo's). In
conventional finance, repo' s consist of the sale of a short-term security with the condition that,
after a period of time, the original seller will buy it back at a predetermined price. Repo's
provide the investor with a money market instrument with precisely the needed maturity thus
eliminating all price risks. For example, an investor may wish to invest funds for a very short
period of time, say, for three days. A treasury bill with a maturity of three days could be
purchased, held for three days and then resold in the secondary market. From the standpoint of
the temporary sellers of securities, repo's represent a source of funds and for the buyer, an
interest-earning investment (Osman, 2001).

In contrast to Repo's, SBBA is not the sale and purchase of money but the sale and purchase
of assets. SBBA could be used by Islamic banks to manage its gap and liquidity by selling
the General Islamic Investment (GIl) or General Islamic Certificates (GIC) and other
approved securities in order to obtain cash for liquidity purposes.

Prepared by - Basharat Hossain, Assistant Professor of Economics, Dept. of Business Administration,

International Islamic University Chittagong, Bangladesh
Page 21
 4. Accepted Bills - Islamic (Ab-I):

As applied to a time draft or bill of exchange, acceptance is the drawee's intention to pay upon
maturity. Acceptances are of two types: commercial (trade) acceptance and banker's
acceptance. It is supported by a third party or acceptance house, and is usually issued to
finance the shipment or temporary storage of foods. By "accepting" the draft, the bank
makes an unconditional promise to pay the holder of the draft a stated amount at a specified
date. Thus, the bank effectively substitutes its own credit for that of a borrower and in the
process issues a negotiable instrument that may be freely traded. BAs are trade-related. The
most frequent original maturity is 90 days. A banker's acceptance generates commissions for the
bank as the bank acts on behalf of the drawee / purchaser to pay the value of the accepted bill to
the beneficiary / seller. A banker's acceptance is also discountable (Osman, 2001).

Islamic Accepted Bill also known as Interest-Free Accepted Bill (lAB) was introduced in
1991. The objectives of introducing lAB are to encourage and promote both domestic
and foreign trade, by providing Malaysian traders with an attractive Islamic financing
product. The lAB is formulated on the Islamic principles of AI-Murabahah (deferred lump-
sum sale or cost-plus) and Bai AI-dayn (debt-trading). AI-Murabahah refers to the selling of
merchandise at a price based on cost-plus profit margin agreed to by both parties. Bai AI-
Dayn refers to the sale of a debt arising from a trade transaction in the form of a deferred
payment sale. There are two types of financing under the lAB facility, namely:-

A) Imports and Local Purchases

The financing would be financed under an al-Murabahah working capital financing mechanism.
Under this concept, the commercial bank appoints the customer as the purchasing agent for
the bank. The customer then purchases the required goods from the seller on behalf of the
bank, which would then pay the seller and resell the goods to the customer at a price, inclusive
of a profit margin. The customer is allowed a deferred payment term of up to 200 days. Upon
maturity of al-Murabahah financing, the customer shall pay the bank the cost of goods plus
profit margin. The sale of goods by the bank to the customer on a deferred payment term
constitutes the creation of debt. This is securitised in the form of a bill of exchange drawn by
the bank and accepted by the customer for the full amount of the bank's selling price payable
upon maturity. If the bank decides to sell the lAB to a third party, then the concept of Bai al-
dayn will apply whereby the bank will sell the lAB at the agreed price.

Prepared by - Basharat Hossain, Assistant Professor of Economics, Dept. of Business Administration,

International Islamic University Chittagong, Bangladesh
Page 22
B) Exports and Local Sales

The bills created shall be traded under the concept of Bai al-Dayn. An exporter approved for
lAB facility will prepare the export documentation as required under the sale contract or letter
of credit. The export documents shall be sent to the importer's bank. The exporter shall draw on
the commercial bank a new bill of exchange as a substitution bill and this will be the lAB.
The bank shall purchase the lAB at a mutually agreed price using the concept of Bai al-Dayn
and the proceeds will be credited to the exporter's account. Domestic sales will be treated in a
similar manner.

5. GOVERNMENT INVESTMENT ISSUES (GIl)

GIl is an instrument to cater to the needs of the government in getting cash. GIl is a
Domestic Ringgit Islamic bond issued by the government of Malaysia to finance development
expenditures. It is structured based on the Al-Bai AI-Inah concept. The underlying principle
used in GIl is Bay al Inah. The central bank will sell an asset to a customer and the
payment is made in cash. They will enter into another sale and purchase contract
whereby the customer will sell the asset back to the central bank. The central bank will
issue the Gil based on syahadah al Dayn.

The formula for the price of GIl is as follows:

(Rate X Time X Face Value)
Price=Face Value+
365
For example the face value of the asset is RM100,000.t he customer will pay cash to the central
bank, then the customer will sell back the asset to the bank on credit for 21 days at 3%. The
selling price is RM 100,000 + (0.03 X 21 X 100,000)/365. The customer's selling price is
100,172.60.

6. ISLAMIC TREASURY BILLS:

The first Islamic Treasury Bills (ITB) issued by BNM was on 17 September 2004. The
underlying principles used are Bay al Inah for the issuance of ITB and Bay Ad Dayn for selling
the ITB in secondary markets. However, TBs could be adapted to a mudaraba basis. Mudaraba
bonds could be issued, so that the government collects the proceeds from banks with short-term
liquidity and acts as the mudarib. This could be done on a continuous basis so that the
government could secure a constant flow of funds through the frequent issuing of mudaraba
bonds. Investment activities financed by the proceeds of mudaraba bonds have to be carefully

Prepared by - Basharat Hossain, Assistant Professor of Economics, Dept. of Business Administration,

International Islamic University Chittagong, Bangladesh
Page 23
studied and chosen so that they can be liquidatedwithin the specified period - three months,six
months or up to one year.

Mudaraba-based TBs can be used to finance certain investment projects or for any other
feasible investment activities. The value of these TBs would be amortized gradually over
time or repaid at the end of the period with profits realized. A third party may, if the need
arises, act as a guarantor to investors (mudaraba-based TBs holders) since the formal
legal opinion of the IFA is that it is lawful for an independent concern to provide this
guarantee on the basis that it is not rewarded for it. In addition to mudaraba-based TBs,
TBs could be musharaka-based. Governments can issue TBs on a musharaka basis to
finance specific projects, so that TBs would represent investment units of equal value.

7. CAGAMAS MUDHARABAH BOND

Cagamas Mudharabah Bond was introduced on I March 1994 by Cagamas Berhad to

finance the purchase of Islamic housing debts from financial institutions that provides
Islamic housing finance to the public. The SMC Mudharabah Bond is structured
using the concept of Mudharabah where the bondholders and Cagamas will share the
profits according to the agreed profit-sharing ratios.

8. Islamic Negotiable Certificates Of Deposit (INCO):

There are two types oflslamic Negotiable Instruments.

A) Islamic Negotiable Instruments of Deposit (INID):

The applicable concept is AI-Mudharabah. It refers to a sum of money deposited with the
Islamic banking institution and repayable to the bearer on a specified future date at the nominal
value of INID plus declared dividend (IIMM).

B) Negotiable Islamic Debt Certificate (NIDC):

The transaction involves the sale of banking institution's assets to the customer at an agreed
price on a cash basis. Subsequently, the assets are purchased back from the customer at
principal value plus profit and settled at an agreed future date.(I1MM). NIDC is based on AI-
Bai Bithaman Ajil (deferred payment sale) and AI-Bai Al-Dayn (debt trading).

a. Investor purchases asset from the Bank on cash basis.

b. Investor re-sells this asset to the Bank at a higher price on credit basis.
c. Bank issues NIDC to the investor.
d. Bank settles this credit to the investor upon an agreed future date.
Prepared by - Basharat Hossain, Assistant Professor of Economics, Dept. of Business Administration,
International Islamic University Chittagong, Bangladesh
Page 24
NIDC can be traded in the secondary market subject to guidelines for Islamic Negotiable
Instruments issued by Bank Negara Malaysia.

Face Value x 100

Price=
Face Value¿ ¿

Pric e x Face Value( at 4 decimal place)

Proceeds=
100

9. Islamic Private Debt Securities (IPDS)

Islamic Private Debt Securities (IDS) has been introduced in Malaysia since 1990.
Subject to Securities Commission and BNM guidelines, the bank may issue Islamic
Bonds/commercial paper to finance its projects and business activities. Now, the IPDS,
which are outstanding in the market, were issued based on the Syariah compliant concept
ofBai Bithaman Ajil, Murabahah and al Mudharabah.

a. The IPDS is rated by Rating Agency Malaysia (RAM) or Malaysia Rating

Corporation (MARC) and may either be bank guaranteed or stand-alone.

b. IPDS may be structured along AI-Bai' Bithaman Ajil, AI-Murabahah. Al-

Mudharabah or Sukuk Al-ljarah concept.

c. The debt created is subsequently securitised to enable trading in the secondary

market under the concept of AI-Bai Al-Dayn (Harlow).

10. AI Rahnu Agreement-I (RA-I)

Under RA-I, the lender will provide a loan to the borrower based on the concept of Qardul
Hasan. The borrower will pledge its securities as collateral for the loan granted. However, in
the event where the borrower fails to repay the loan on the maturity date, the lender has the
right to sell the pledged securities and use the proceeds from the sale of the securities to
settle the loan. If there is surplus money, the lender will return the balance to the borrower.
BNM will use RA-I as a liquidity management tool for its money market operations. Return
from the RA-I will be in the form of a gift (hibah) and is based on the average interbank
money market rates.

Prepared by - Basharat Hossain, Assistant Professor of Economics, Dept. of Business Administration,

International Islamic University Chittagong, Bangladesh
Page 25
Islamic Inter-bank Fund Market (IIFM) – Bangladesh, the separate call money market for
Islamic banks in Bangladesh:

Islamic Inter-bank Fund Market (IIFM) -- for sharia-based banks started its journey on June 3,
2012. In such a market, transactions are based on profit instead of interest. Bangladesh Bank
Governor Atiur Rahman inaugurated the IIFM at the central bank.

On the first day, Islami Bank Bangladesh Ltd offered funds worth Tk 100 crore, while four banks
applied for taking Tk 60 crore from the funds.

The BB governor said the IIFM has been formed in the model of the traditional call money
market to remove the temporary and short-term liquidity crisis of the Islamic banks. The Islamic
Bond Fund of the central bank will act as the custodian of the IIFM and will not charge any fees
for the fund.

According to rules, if any bank has excess fund, it will invest the amount in the IIFM for one
day. Another Islamic bank requiring fund will borrow the money from the IIFM for one day. The
rate of profit in the Islamic bank call money market will be determined on the basis of the profit
the bank gives to its depositors on a three months' deposit.

Foreign exchange market in Islam:

The rule of trade in currencies:

Currency trading may be permissible on one condition that the payment should occur on the
same in the contract’s council, if the currency is equal The evidence narrated by Abada Ben Al-
Samit may Allah be pleased with him said: The Messenger of Allah peace be upon him: (gold for
gold, silver for silver, wheat for wheat, barley for barley, dates for dates, salt for salt, like for
like, hand in hand, if these types are different the sell as you like, hand in hand) Narrated by
Muslim (1587).

The “Total Fataawa Ibn Baaz” (19/171- 174):

Transactions, buying and selling in currencies are permissible, but only if the exchange be hand
in hand if the currencies were different, Example selling the currency of the Libyan currency

Prepared by - Basharat Hossain, Assistant Professor of Economics, Dept. of Business Administration,

International Islamic University Chittagong, Bangladesh
Page 26
exchange for the U.S. Dollars or Egypt the transaction  should be done hand in hand within the
council, but if the payment was delayed or differed then it’s not permissible, because that case it
is considered a form of usury-based (Riba) transaction, it must be the same sitting of the Council
hand in hand if the currency is different, but if they are of one type must be two conditions:
symmetry and same sitting of the Council, as per the Prophet saying peace be upon him: (gold
for gold , and silver with silver… Then he mentioned the Hadith).

And currencies as before if it was different then it is permissible with the differentiation and
payment may be in the same sitting of the Council, and if one type such as dollars, dollars, or
dinars, dinars must be in the same sitting of the Council, and uniformity.

Islamic financial instruments:

 IDC, IIC and MB 

 
Three potential instruments proposed in the Seminar on Developing a System of Financial
Instruments, jointly sponsored by the Islamic Development Bank and the Government of
Malaysia, held in Kuala Lumpur 1986, were Islamic Deposit Certificates (IDCs), Islamic
Investment Certificates (IICs) and Muqarada Bonds (MBs). These appeared promising the IDC
proceeds are meant to be used by the issuing bank for general purposes, while IIC proceeds are
meant for investment in a specific project or activity by the issuing bank. The MBs proceeds
are meant to be used for income-yielding public utility projects, such as electricity and
telecommunications, and infrastructure development projects such as construction of roads and
bridges.
 
The common denominator for all the above three instruments is that they are all based on the
principle of profit sharing. The holders of IDC and IIC will also share in the losses, if any, but
not the holders of MBs, as the nominal value of MBs would be guaranteed by the Government,
which is a third party independent from the other two. It is of interest to note that Muqarada
Bonds have already been adopted as a financial instrument in Jordan, though with a limited
scope.

Prepared by - Basharat Hossain, Assistant Professor of Economics, Dept. of Business Administration,

International Islamic University Chittagong, Bangladesh
Page 27
 Attention!
Also available at:

[Link]

Prepared by - Basharat Hossain, Assistant Professor of Economics, Dept. of Business Administration,

International Islamic University Chittagong, Bangladesh
Page 28