Chapter 1

Introduction to Islamic Banking and Finance

 Introduction
 The financial system is a vital component of any modern
economy.

 It mobilizes and drives financial resources in global capital

markets through financial institutions and markets.

 Financial institutions are intermediaries through which

resources are channeled towards efficient allocation of funds in
the economy.

 Financial markets are the arenas or mechanism by which

financial instruments are traded.
 Managing the payment
system
Provide mechanism for
saving and borrowing

Bridge different portfolio

Mechanism of pooling preferences of supplies
of funds and financing and demanders of funds
larger scale of
individual projects
Allocation of funds to the
most efficient use
Mechanism of
transferring economic
resources: time, agent,
Managing uncertainty
geography

Offers facilities & markets

Price risk and enable risk to
enabling wealth holders to
be transferred between
change the structure of
different portfolio according
their portfolio of assets &
to their abilities &
liabilities
willingness to absorb them

Offers specialist services

Deal with asymmetric
Eg. insurance
information
 Financial Intermediation
Savings &
Investment Financing

Surplus Units Deficit Units

• Individuals Financial • Individuals
Intermediary
• Businesses (e.g. bank) • Businesses
• Government • Government

Return on Return on
investment & financing
savings

Bank’s Liabilities Bank’s Assets

What is Islamic Banking?

• Islamic Banking is a banking activity that is based on

shari'ah principles.

• It does not allow (prohibited) the paying and receiving

of interest and promotes profit sharing in the conduct
of banking business
Shari'ah Principles in
Islamic Banking
 Islamic Banking has the same purpose as conventional
banking except that it operates in accordance with the
rules of shari'ah, known as Fiqh al-Muamalat (Islamic
Rules on Transactions).

 The basic principle of Islamic banking is the sharing of

profit and loss and the prohibition of riba’ (interest).

 Amongst the common Islamic concepts used in Islamic

Banking are profit sharing (Mudharabah), safekeeping
(Wadiah), joint venture (Musyarakah), cost plus
(Murabahah) and leasing (Ijarah).
Evolution of Islamic Banking &
Finance in Malaysia
1) Phase 1: Establishment of Islamic Banking & Financial
Institutions (1967-1992)
2) Phase 2: Conventional banks were allowed to offer Islamic
financial products and services under Islamic
Banking Scheme (1993-2002)
3) Phase 3: Conventional banks were allowed to set up Islamic
subsidiaries (starting in 2003)
4) Phase 4: International integration of the domestic Islamic
banking system (starting in 2003)
MALAYSIAN HISTORY OF ISLAMIC BANKING

Year Activities

1960s Pilgrim Fund Board (Tabung Haji) was established in 1969.

1970- Bank Pembangunan Malaysia Berhad was incorporated in 1973 as a
1980s government conduit to strategically develop and promote active participation
of Bumiputera entrepreneurs and the first Islamic financing scheme was
introduced under the concept of Bai Muajjal (credit sale)
1983 Bank Islam Malaysia Berhad was set up in 1983, under Islamic Banking Act,
1983.
1984 Syarikat Takaful Malaysia Berhad (Takaful Malaysia) was incorporated on the
29th of November 1984. (1st Islamic Insurance Company)
1993 Introduction of Interest Free Banking & Islamic Banking Window
1994 Introduction of Islamic Inter-bank Money Market •
Dual banking system for 3 anchor banks i.e Maybank, Bank Bumiputera •
Malaysia Bhd (BBMB) & Public Bank
1997 Formation of shari'ah Advisory Council (SAC) for Islamic Banking & Takaful
1999 Establishment of Bank Muamalat – 2nd full fledged Islamic Bank(wing of
BBMB).
2001 Formation of the Financial Sector Masterplan which outlined a detailed long
term strategy to promote the Islamic banking industry as a niche area
MALAYSIAN HISTORY OF ISLAMIC BANKING
Year Activities

2003 • Establishment of Islamic Banking Subsidiary for conventional bank

• BNM issued a guideline on the Specimen reports and Financial Statements
Licensed Islamic Banks (GP8-i)
• The Central bank of Malaysia Act 1985 was amended as to enhance the
role and functions of SAC

2004 Entrance of Kuwait Finance House, Al Rajhi & Asian Finance (a consortium •
of Qatar Islamic Bank, RUSD Investment Bank Inc. & Global Investment
House)
A guideline on the issuance of credit card based on shari'ah principles •
(Credit Card-i)
Market Risk Capital Adequacy Framework for Islamic banks was issued •
BNM issued the guidelines on the governance of shari'ah Committee for •
the Islamic Financial Institutions to rationalize and streamline the
functions and duties of shari'ah bodies of the financial institutions
2005 BNM approved the Islamic subsidiaries structure to replace of Islamic •
window institutions structure
Foreign participation in Islamic subsidiaries and allowed to have up to 49% •
equity
Announcement the tax neutrality policy for Islamic banking and finance •
Government Investment Act 1983 was amended and renamed as •
Government Funding Act 1983
MALAYSIAN HISTORY OF ISLAMIC BANKING

Year Activities

2006 Launched of the Malaysia International Islamic Financial Centre •

A new category of licenses, International Islamic Banks (IIB) under the •
Islamic Banking Act 1983 were issued to qualify foreign and Malaysian
financial institutions that conducted businesses in international currencies
Labuan offshore Islamic banks and the Islamic divisions of the offshore •
banks are granted approval to establish operational offices anywhere in
Malaysia
Approval for the setting up International Currency Business Units (ICBU) •
within the Islamic financial institutions
2010 Targeting Islamic banking and finance sector constitutes 20% of overall
market
 Validity and Permissibility
 Valid is the contract that meets its requirements and conditions.

 Permissible (Halal) is the contract that is used to obtain Halal

(Permissible) ends.

 A valid contract is not necessarily Halal (permissible).

 Initiating a marriage contract with a woman whereby all conditions are

fulfilled but with the intention to divorce her the other day (just to
obtain the sexual pleasure) is a valid contract, but it is not Halal.

 Selling guns to criminals is valid, but it is not Halal.

 Validity is based on the form of the contract while permissibility is

based on the substance of the contract and the intention of the
contractors.
Basis of Islamic Banking and Finance

The Shari’ah
• Defines man-to-God and man-to-man relationships

• Shari’ah is the divine prescriptions in the form of faith and

belief, laws and moral norms broadly classified into two
strands:
– ibadah (worship and devotional practices)
– muamalat (civil transactions)

• The primary sources of the Shari’ah are the Qur’an and

Sunnah
Basis of Islamic Banking and Finance

Figure 1.1: Shari’ah as the Basis of Islamic Banking and

Finance
 MAQASID/OBJECTIVES OF Shari'ah
The objectives of shari'ah are as follows:
1. To protect religion/ad-deen: which Islam regulates the
relationship between human and his creator and
human versus human
2. To protect `aqal’ – which permit the right of promoting
& attaining knowledge (therefore forbids consumption
alcohol)
3. To protect the life or living of human being – as such
punish those who transgress against it
4. To protect individual descendant of generation – to
ensure integrity & unlawful relationship
5. To protect asset / wealth of individual and public – to
encourage people to work hard & living lawfully,
prohibits exploitation & injustice 14
Basis of Islamic Banking and Finance

The Qur’an
• The first source of the Shari’ah
• General and specific rules on religious, commercial, political,
economic, legal and social norms
• Emphasis on mutual consent and consensus among
consenting parties
• Prohibits exploitative measures:
○ Excessive risk or uncertaintly (gharar)
○ Usary or interest (riba)

• Prohibits cheating and corrupt practices in the management

of funds
• Does not allow dealings in prohibited products
Basis of Islamic Banking and Finance

The Sunnah
• The second primary source of the Shari’ah

• Meant to further explain the injunctions of the Qur’an

• For example, there are many prophetic traditions that deal

with riba that highlight the affirmative evidence of the
prohibition of riba already mentioned in the Qur’an
 PRIMARY SOURCES : AS-SUNNAH

•Al-
Hadith is the saying, deeds and approvals of
Prophet Muhammad SAW
•In
Shariah, Hadith describes as Sunnah ( the way or
manner) of Prophet Muhammad.
•There are three kinds of Sunnah:
a. A qaul or a ‘saying’ of the Prophet Muhammad
which has a bearing on a religious question.
b. A fi’l which represent an ‘action’ or ‘practice’ of
the Prophet Muhammad.
c. A taqrir or a ‘silent approval’ of Prophet
Muhammad of action or practice of another.

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  SECONDARY SOURCES
 IJMA’:

o IJMA’ is the verbal noun of the Arabic word ajma’a which has two
meanings: To determine, To agree upon something.
o The consensus of the jurists in understanding, interpreting and applying
the teachings of the Quran and the Sunnah forms the third basic source
of the Shariah.
o Ijma’ means a unanimous agreement among the mujtahidun of a Muslim
community on any Shariah ruling in a particular period following the
demise of the Prophet Muhammad (Peace Be Upon Him).
o However, it is difficult to classify a particular Shariah ruling as ijma’
considering the wide coverage of Islamic territory and the emergence of
the various school of thoughts among the Muslim community.
o Therefore, the majority of Islamic scholars are of the opinion that ijma’
only happened during the period of the companions of Prophet
Muhammad PBUH before they migrated to other territories.
o As such, the claim that ijma’ had occurred after such period is quite
difficult to be accepted.

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 EXAMPLE OF IJMA’

• The 20 rakaat of Tarawwih salah that is prayed in Ramadan from

the 1st of Ramadan until the last day of Ramadan every day, and
which is prayed after Isyak prayer and in which the whole Quran
is recited. This was the Ijma’ of the Sahabat (R.A.) (companions)
during the time of Umar(R.A.), this is carried right from the time
of Umar(ra) until today.
• Another example of Ijma is the second Azan of Jumah(Friday),
which was the Ijma’ of sahabat (R.A.) during the time of Uthman
(R.A) which is followed through out the world.
• This is because of the Sahih Hadith of the Prophet(PBUH) said:
"Hold fast to My Sunnah and the Sunnah of the Khulafaa-el-
Rashidin" (the Rightly Guided Caliphs). In this hadith two Sunnats
are mentioned, one of Rasulullah (Sallallaahu Álayhi Wasallam)
and the other of the Sahabat (R.A)

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  SECONDARY SOURCES
 Qiyâs

o Qiyâs is a method that uses analogy – comparison – to derive Islamic legal

rulings for new developments.
o Qiyâs can be defined as taking an established ruling from Islamic Law and applying it
to a new case, in virtue of the fact that the new case shares the same essential
reason for which the original ruling was applied.
o Qiyâs, therefore, is a method that Muslim jurists use to derive a ruling for new
situations that are not addressed by the Qur’ân and Sunnah, like many new
developments of our age and like the customs of people not encountered in Arabia
during the time of the Prophet (peace be upon him).
o By way of qiyâs, these issues can be referred back to those that are explicitly
mentioned in the sacred texts.
o When we know the reason why something in Islamic Law is obligatory, preferred,
permitted, disliked, or forbidden, then if something else shares the same reason, it
can be given the same legal ruling.
o In such issues, the scholars have derived law through analogical deduction on the
basis of the provisions of Quran and the Sunnah on some similar situation.
o The emphasis of qiyas is identification of a command cause between the original and
new case.
o It has been regarded as a legal source, which contributes significantly in deciding new
unresolved issues.
o For example, the Quran forbids the use of alcohol but does not mention
narcotics. Because alcohol and narcotics are both intoxicating, one may use
qiyas to determine that Islamic law forbids narcotics as well.

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  SECONDARY SOURCES
 IJTIHAD:

o The ijtihad of Islamic jurists is known as the science of Islamic

jurisprudence, which is “an endeavor undertaken by the mujtahid in
formulating a particular rule and value of a subject matter that is not
clearly explained whether by the Al-Quran or Al-Sunnah”.

o Mujtahid, required:
o Enough knowledge of Arabic so that the scholar can read and understand
both the Qur'an and the Sunnah.
o Extensive comprehensive knowledge of the Qur'an and the Sunnah. More
specifically, the scholar must have a full understanding of the Qur'an's legal
contents. In regards to the Sunnah the scholar must understand the specific
texts that refer to law and also the incidence of abrogation in the Sunnah.
o Must be able to confirm the consensus (Ijma) of the Companions, the
Successors, and the leading Imams and mujtahideen of the past, in order to
prevent making decisions that disregard these honored decisions made in
the past.
o Should be able to fully understand the objectives of the Shariah and be
dedicated to the protection of the Five Principles of Islam, which are life,
religion, intellect, lineage, and property.

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  SECONDARY SOURCES
 IJTIHAD:

o Be able to distinguish strength and weakness in reasoning, or in other

words exercise logic.
o Must be sincere and a good person.

o In the context of Ijtihad, Shariah and Islamic jurisprudence will be

interpreted to have the same meaning, although from academic
perspective there are some differences between the two. Yet, both are in
the same discipline which discusses Allah SWT’s rules, regulations and
legislation in matters of worship, family, financial, criminal, state
administration, international relation and others.
o Since the basis of Islamic jurisprudence is also Al-Quran and Al-Sunnah,
the rulings derived through the exercise of ijtihad of Islamic jurists are also
considered as Shariah rulings because they are based on the same
sources.
o Therefore, Islamic jurists define Islamic jurisprudence as “a science that
explains the Shariah rulings which are derived from the detail evidences or
authorities”.

22
The underlying principles of Islamic
banking business

 Al-Riba
◦ Any excess, increase, expansion, growth

 Al-Maysir
◦ Any acts of gambling/speculation that relate to the
financial instrument
◦ Eg: Casino

 The Forbidden
◦ Any forbidden items
◦ Eg: Short-guns,
Origins and Historical Overview of
Islamic Banking and Finance

• The history of Islamic finance is divided into two general

aspects:

• The early days transactions

• The modern-day experiments

Origins and Historical Overview of
Islamic Banking and Finance

The early days transactions

1. The Era of the Prophet

2. The Period of Orthodox Caliphate (632 – 661 C.E.)

3. Period of the Noble Companions and the Succeeding

Generations

4. The Umayyad and Abbasid Eras

Origins and Historical Overview of
Islamic Banking and Finance

The Era of the Prophet

The prevailing modes of transactions during this era include:
• Shirkah (partnership) based on profit-and-loss sharing (PLS)
• Al qard Al hasan (benevolent loan)
• Salam (Forward) contract
• Sarf (exchange of money), i.e. gold for gold and silver for
silver at the same sitting
• Ijarah (leasing)
• Trans-regional trade involved trade caravans from Mecca to
Syria and vice versa
Origins and Historical Overview of
Islamic Banking and Finance

The Period of Orthodox four rightly-guided Caliphs: (632 – 661

C.E.)
• Abu Bakr Assidique (632 – 634)
Failure of a segment of the Islamic state to pay the
compulsory alms known as zakat.
• Umar ibn Al-Khattab (634 – 644)
- Dramatic reforms in the economic policy of the state.
- The introduction of a centralized and permanent Bait al-
mal (the Treasury House)
• Uthman ibn Affan (644 – 656)
The introduction of the first Muslim coins
• Ali ibn Abi Talib (656 – 661)
Origins and Historical Overview of
Islamic Banking and Finance

Period of the Noble Companions and the Succeeding

Generations marked by:

• Building on the reforms introduced by the Prophet (PBUH)

• Tremendous increase in commercial interaction between

merchants in the Islamic state and elsewhere

• Further development of fiqh (Islamic jurisprudence)

• Advanced economic reforms based on self-exerted judgment

(ijtihad)
Origins and Historical Overview of
Islamic Banking and Finance
The Umayyad and Abbasid Eras
• Issuance of the first Islamic dirham (containing the crescent,
the star, and bismillah)

• Shifting of the Treasury House to Damascus, capital

of the Umayyad, where a
bigger building was designated
as Bait al-Mal

• The Treasury House still

significant during the Abbasid
period and Mamluk era

• The dinar and dirham still

used as mediums of exchange
Origins and Historical Overview of
Islamic Banking and Finance

Modern-Day Experiments of Islamic Finance marked by:

• The Ottoman Empire’s fall resulting in fragmentation of

Muslim nation into different countries

• Prevalence of interest-based banking and finance system

• Lack of awareness among Muslim communities across

nations on whether to return to Islamic roots

• Experiments in Islamic finance in Egypt, Malaysia, and

Pakistan: the basis of modern Islamic banking and finance
Origins and Historical Overview of
Islamic Banking and Finance
Timeline of Modern-day Experiments of Islamic
Banking and Finance from 1962 to 1975
• Initial Reforms in the Banking Industry in Pakistan in 1962

• Mit Ghamr Local Savings Bank in Egypt of 1963 (“the first

modern-day trial of Islamic baking”)

• The Malaysian Pilgrims Savings

Board, Tabung Haji of 1969
(managing savings of prospective
pilgrims by investing in Sharī’ah-
compliant investments)

• The Founding of the Islamic

Development Bank (IDB) in 1975
Origins and Historical Overview of
Islamic Banking and Finance
The functions of the IDB are:
• To participate in equity capital and to grant loans

• To provide financial assistance to member countries

• To establish and operate special funds for specific purposes

• To accept deposits and to mobilize financial resources

through Sharī’ah compatible modes

• To promote foreign trade, especially in capital goods, among

member countries
Origins and Historical Overview of
Islamic Banking and Finance

Dubai Islamic Bank (DIB)

The first fully-fledged Islamic world commercial bank in 1975.
Operates five main business groups:

• Retail banking

• Corporate banking

• Real estate

• Investment banking

• Proprietary trading investments

Origins and Historical Overview of
Islamic Banking and Finance
Timeline of Modern-day Experiments of Islamic banking and
finance from 1962 – 1975

Figure 1.2:
Timeline of
Modern-day
Experiments of
Islamic banking
and finance
from 1962 to
1975
Conceptual Arguments for Islamic
Banking and Finance

The fundamentals of Islamic banking and finance business are:

• Interest-free

• Ethical

• Asset-based and asset-backed

• Partnership investment based on profit and loss sharing

(PLS) between financer and entrepreneur
The Development of Islamic Banking
and Finance Industry

• Emergence of the modern Islamic banking and finance

industry in the 1960s
• Gradual expansion of the Asian markets between the 1980s
and ‘90s
• Introduction of Islamic insurance (takaful)
• Introduction of project financing with the support of the IDB
• Introduction of sukuk (Islamic bonds) and equities markets
in the 1990s
• Internationalization of Islamic banking and finance from the
early 2000s
The Development of Islamic Banking
and Finance Industry

Figure 1.3: Total Global Islamic Banking Assets

Growth 2012
Components of Islamic Banking and
Finance Industry

The four major components of the Islamic banking and finance

industry are:

1. Islamic banking

2. Takaful

3. Islamic capital markets

4. Islamic non-bank financial institutions

These form the Islamic financial architecture and infrastructure

Components of Islamic Banking and
Finance Industry

Islamic Banking

The Islamic banking component:

• Deposit-taking and finance of institutions to meet needs of
Muslim customers and investors

• In the form of:

- Fully fledged Islamic banks
- Islamic subsidiaries or
- ‘Windows’ of conventional banks
Components of Islamic Banking and
Finance Industry

Takaful (Islamic Insurance)

• Takaful based on mutual cooperation, common welfare and

general good of society
• Development of modern takaful began with debates about
legality of conventional insurance schemes
• Controversy resolved by the Islamic Fiqh Academy in
Resolution No. 9 of 1985
• Takaful and retakaful significant in managing and mitigating
risks in Islamic banking and finance
Components of Islamic Banking and
Finance Industry
The Islamic Capital Markets (ICM)
• ICM is a special market where investment activities do not
contradict the principles of the Sharī‘ah

• The Islamic Capital Market is free riba, gharar and maysir

• The market players include:

- Brokerage houses
- Investment banks
- Fund management institutions
- Islamic asset management institutions
The Islamic Capital Markets (ICM)

• Various international bodies established to study, promote,

develop and set standards for Islamic finance products
include:
- International Islamic Financial Market (IIFM)
- Islamic Financial Services Board (IFSB)
- Accounting and Auditing Organization for Islamic
Financial Institutions (AAOIFI).
Components of Islamic Banking and
Finance Industry

Islamic non-bank financial institutions

• Islamic financial institutions that play a facilitative role in

Islamic society ensuring economic development through
non-bank financing

• They support liquidity needs of major agents in the economy

• They include: finance companies, Islamic housing

cooperatives, Islamic microfinance institutions, waqf
management institutions, private equity /venture capital
firms, hajj and zakat management bodies
Components of Islamic Banking and
Finance Industry
Islamic financial architecture and
infrastructure
Crucial support for Islamic financial services:
• payment-settlement, legal institutions and framework
• safety net
• liquidity support providers
• corporate governance e.g Sharī‘ah governance structure
• standard setters for financial supervision and infrastructure
• rating and external credit assessment institutions
• financial statistics and information providers
• knowledge management/HR development institutions
• research and development institutions.
 Operating Structures of Islamic
Banking and Finance Industry

Key operating mechanisms of Islamic banking and finance

industry include:

• Fund mobilization

• Fund utilization

- Sharing modes
- Sale modes
- Leasing modes
Key Operating Mechanisms of
Islamic Banking and Finance

Figure 1.4: Key Operating Mechanisms of Islamic

Banking and Finance
Key Operating Mechanisms of
Islamic Banking and Finance

Fund mobilization
The process of raising funds to establish a viable financial
institution through the sale of shares to investors and
receiving funds from depositors. Features include:

• An ethical manner
• Net equities owned by shareholders
• Investment deposits
• Demand deposits
Key Operating Mechanisms of
Islamic Banking and Finance
Fund utilization
The process of using the funds realized in Sharī'ah-compliant
business:
Sharing modes - Partnership where funds initially mobilized
are invested in Sharī'ah-compliant business; parties share
profits or loss
Sale modes – The bank purchases an item on behalf the client
and resells it to them on a deferred basis or immediately
Leasing modes - The rent of an asset or hire purchase where
a rental fee is paid for a stipulated period of time mutually
agreed by the parties
Debt Financing – Extension from existing conventional
practices
The Development of Islamic Banking
Products
• Islamic banking products - financial tools through which the
financial institutions carry out business

• Designed to suit conventional market needs while retaining

the true nature of Islamic financial transactions

• Involve profitable and non-profitable dealings such as:

- zakat (alms)
- waqf (charitable endowment)
- tabaru‘at (gratuitous contracts)
The Development of Islamic
Banking Products

• Islamic banking products initially based on ideas of equity

partnership or partnership modalities

• Early jurists employed ijtihad in developing Sharī‘ah-

compliant products

• Emphasis should be on developing Sharī‘ah-based

rather than Sharī‘ah-compliant financial products
The Growth of Islamic Banking
and Finance

• Islamic banking and finance being integrated into the global

economy

• The practice of Islamic banking and finance has now been

accepted as an alternative to conventional financial systems

• Acceptance attracts new non-Muslim experts, professionals

and financial institutions
 Islamic Banking Today: The Size of
the Industry

• The industry has more than doubled in size since 2006

• Sharī‘ah-complaint assets rose by 8.85% from US$ 822

billion in 2009 to US$ 895 billion in 2010

• By end of 2011, total estimate of Sharī'ah-compliant assets

was US $1.3 trillion

• Rapid growth experienced in the Gulf Cooperation Council

(GCC) countries over the last decade

• Growth and expansion of Islamic finance industry continued

at the time of global financial crisis
Total Assets of Islamic Banks
in the GCC Region
Figure 1.5: Total Assets of Islamic Banks in the GCC
Region
The World-wide Spread of Islamic
Banking

• Islamic commercial banking experiencing a huge expansion

in products and areas of influence across the world.
• 2010 estimates show Islamic banks and financial institutions
number 430 across over 75 countries.
• Islamic banking spans the Middle East, North Africa, South-
East and central Asia, sub-Saharan Africa, and western
Europe.
• More than 191 leading conventional banks in Europe and
America have opened Islamic banking windows or
subsidiaries such as Standard Chartered Bank, Citibank,
HSBC, ABN AMRO, and UBS.
Global Coverage of Islamic Finance

Figure 1.6: Global Coverage of Islamic Finance

Multinational Islamic Banks

The main multinational Islamic banks are:

• Jordan Islamic Bank – 1978/1979

• Faisal Islamic Banks in Egypt and in Sudan – 1977/1978

• Kuwait Finance House - 1977

• Al Rajhi Bank - 1987

• Islamic Development Bank (IDB) - 1975

Future of Islamic Finance Industry

• Islamic finance set to continue significant growth path

• Legal and regulatory challenges still face the emerging

Islamic financial industry

• Islamic finance has the potential of being an alternative

mode of finance

• Islamic finance assets expected to grow consistently at 15%

per annum and exceed USD 1 trillion by 2016

• Global spread of Islamic finance products likely to soon

engulf Latin America and elsewhere
TUTORIAL QUESTIONS

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