Islamic Banking and Finance

Chapter 1- Introduction

BY: D R. D A N A A L Z AYA N I
2022
Basis of Islamic Banking and Finance
Islamic Finance

Shariah Finance

• Shariah scholars divided contracts into: Shariah compliant vs. Shariah based
 Shariah
• Shariah is the Islamic law.
• Shariah defines man-to-God and man-to-man
relationships.
• Shariah is the Divine prescriptions in the form of
faith and belief, laws and moral norms broadly
classified into two strands:
oibadah (worship and devotional practices)
omuamalat (civil transactions)
• The primary sources of the Shariah are the Quran
and Sunnah.
Shariah
 The Quran
• The first source of the Shariah.
• The Quran is defined as a book that contains the
speech of Allah revealed to the Prophet Muhammad in
Arabic and transmitted to us by continuous testimony
(tawatur).
• Both the words and the meanings of the Quran come
from Allah.
• The translation of the Quran into another language or
its commentary whether in Arabic or other languages
are not part of the Quran.
• Only in its original form in Arabic it is considered a
revelation from Allah.
 The Quran
• The Quran provides general rules on religious, commercial, political,
economic, legal and social norms.
• How many chapters in the Quran?
• How many verses in the Quran?
• The Quran that we recite today was revealed in pieces and in an order not as
we see today. Why?
‫َوَقاَل اَّلِذيَن َكَفُر وا َلْواَل ُنِّز َل َعَلْيِه اْلُقْر آُن ُج ْمَلًة َواِح َدًة ۚ َكَٰذِلَك ِلُنَثِّبَت ِبِه ُفَؤاَدَك ۖ َوَر َّتْلَناُه َتْر ِتياًل‬
)32:‫(الفرقان‬
And the unbelievers say, “Why was the Quran not sent to him in one single
revelation?” (it was revealed in stages) so that we may strengthen your heart.
And we revealed it in well-organizded portion.
 The Quran
The Quran gradual revelation afforded opportunities:
• To the believers to reflect over its meaning and to retain it in their memories
• To show them how these verses could be implemented.
• To strengthen their hearts by providing continuous contacts and renewal of
spiritual strength
• To enable them to understand the Quran
• To impose laws gradually and not all at once so as to avoid hardships to the
believers. For example: the ban on the consumption of alcohol was
introduced gradually . 1st –2:219, 2nd 4:43, 3rd 5:93
 The Quran
• With every revelation, the Prophet was instructed as to the exact order and
location of the newly revealed verses.
• Both the order of the verses within a particular surah and the sequence of
the surah themselves were arranged and determined by the Prophet in the
year of his demise.
 Sunnah
• The second primary source of the Shariah.
• Sunnah refers to the traditions of the
Prophet Muhammad that include his sayings,
actions and silent approvals.
• Meant to further explain the rulings of the
Quran.
 Prohibited elements in Islamic Finance
• Riba: usury or interest
• Gharar: excessive risk or excessive uncertainty
• Maysir: gambling
• Dealings in prohibited products: example: pork meat and products, alcohol,
tobacco.
 Riba
• The word used by the Quran concerning 'interest' is Riba.
• The literal meanings of Riba are money increase, increase of anything or
increment of anything from its original amount.
• In Shariah, Riba refers to the premium that must be paid by the borrower to
the lender along with the principal amount as a condition for the loan or for
an extension in its maturity.
• Making money from money is prohibited in Islam.
Riba

BD1000

Lender Borrower

BD 1000 +
BD100

Riba
Is all increase in money considered as Riba in Islam?

Why Riba is prohibited in Islam?

 Riba Verses
‫َذ َك َأ‬ ‫ْل‬ ‫ا‬ ‫ا‬‫َط‬ ‫َّش‬‫ال‬ ‫ُط‬ ‫ي‬ ‫َّل‬ ‫ا‬ ‫ُقو‬ ‫ا‬ ‫َك‬ ‫اَّل‬ ‫و‬ ‫ُقو‬ ‫اَل‬ ‫ا‬ ‫ال‬ ‫و‬‫ُل‬
‫ُك‬‫• اَّل ي ْأ‬
‫َّن‬
‫ِب ُهْم‬ ‫ِل‬ ‫َن َمِّس‬ ‫ِم‬ ‫ُن‬ ‫ْي‬ ‫ُه‬ ‫َّب‬ ‫َخ‬‫َت‬
‫َي‬ ‫ِذ‬ ‫ُم‬ ‫َي‬ ‫ِإ َم‬ ‫َن‬ ‫ُم‬ ‫َي‬ ‫َب‬ ‫ِّر‬ ‫َن‬ ‫ِذ َن َي‬
‫َأ‬
‫َقاُلوا ِإَّنَما اْلَبْيُع ِمْثُل الِّر َبا َو َح َّل الَّلُه اْلَبْيَع َوَح َّر َم الِّر َبا َفَمْن َج اَءُه َمْوِع َظٌة ِمْن َر ِّبِه َفاْنَتَهى‬
‫َأ‬ ‫ُأ‬ ‫َأ‬
‫َفَلُه َما َس َلَف َو ْمُر ُه ِإَلى الَّلِه َوَمْن َعاَد َف وَلِئَك ْصَح اُب الَّناِر ُهْم ِفيَها َخ اِلُدوَن‬
)275:‫(البقرة‬
Those who consume interest cannot stand [on the Day of Judgment] except as
one stands who is being beaten by Satan into insanity. That is because they
say, "Trade is [just] like interest." But Allah has permitted trade and has
forbidden interest.
 Riba Verses
)276 :‫• َيْمَح ُق الَّلُه الِّر َبا َوُيْر ِبي الَّصَدَقاِت َوالَّلُه اَل ُيِح ُّب ُكَّل َكَّفاٍر َأِثيٍم (البقرة‬
.Allah deprives interest of all blessing, whereas He blesses charity with growth

‫وا‬ ‫َذ‬‫ َف َل ْف ُلوا َفْأ‬. ‫ْؤ ي‬ ‫ُك‬ ‫ا‬ ‫ال‬ ‫ا‬ ‫وا‬ ‫َذ‬ ‫َّل‬‫ال‬ ‫ُقوا‬ ‫ا‬ ‫وا‬ ‫آ‬ ‫ي‬ ‫َّل‬ ‫ا‬ ‫ا‬ ‫• ا َأ‬
‫ْرٍب‬ ‫َح‬‫ِب‬ ‫ُن‬ ‫َع‬ ‫َت‬ ‫ْم‬ ‫ْن‬‫َن ِإ‬ ‫ِن‬ ‫ِم‬ ‫ُم‬ ‫ْم‬‫ْنُت‬ ‫ْن‬ ‫َب‬ ‫ِم‬ ‫ِق‬
‫َأَي َن ِّر ِإ‬ ‫َب‬ ‫َم‬ ‫َو ُر‬ ‫َه‬ ‫َّت‬ ‫ُن‬ ‫َم‬ ‫َن‬ ‫ِذ‬ ‫َي َه‬
‫ُّي‬
)279-278 :‫ِمَن الَّلِه َوَر ُس وِلِه َوِإْن ُتْبُتْم َفَلُكْم ُر ُءوُس ْمَواِلُكْم اَل َتْظِلُموَن َواَل ُتْظَلُمون (البقرة‬
You who believe, beware of God: give up what remains [due to you] of interest, if you
are true believers. If you do not, then be warned of war from Allah and His
.Messenger
 Riba in Hadith
.‫ َلَعَن آِكَل الِّر َبا َوُمْؤِكَلُه َوَش اِهَدْيِه َوَكاِتَبُه‬-‫صَّلى الله عليه وسَّلم‬- ‫• عْن اْبِن َمْس ُعوٍد َأَّن الَّنِبَّي‬
Ibn Mas'ud narrated: "The Messenger of Allah cursed the one who consumed Riba, and
the one who charged it, those who witnessed it, and the one who recorded it."

:‫ قال‬-‫صَّلى الله عليه وسَّلم‬- ‫ أَّن رسول الله‬-‫رضي الله عنه‬- ‫• عن أبو هريرة‬
‫ وقتُل النفِس‬، ‫ والِّس حُر‬،‫ الشرُك باللِه‬:‫ وما هَّن ؟ قال‬،‫ يا رسوَل اللِه‬:‫ قالوا‬، ‫"اجتنبوا السبَع الموبقاِت‬
‫ وقذُف المحصناِت‬، ‫ والتولي يوَم الزحِف‬،‫ وأكُل ماِل اليتيِم‬،‫ وأكُل الربا‬،‫التي حّر م اللُه إال بالحِّق‬
." ‫المؤمناِت الغافالِت‬
The Prophet said, "Avoid the seven great destructive sins." The people enquire, " What
are they? "He said, "To join others in worship along with Allah, to practice sorcery, to kill
the life which Allah has forbidden except for a just cause, (according to Islamic law), to
eat up Riba (usury), to eat up an orphan's wealth, to give back to the enemy and fleeing
from the battlefield at the time of fighting, and to accuse, chaste women, who never
.even think of anything touching chastity and are good believers
What are the differences between Riba and profit?
Riba and Profit

Riba Profit
Riba is the premium paid by the Profit is the difference between the
borrower to the lender along with value of production and the cost of
principal amount as a condition for production.
the loan.
Riba is predetermined, and hence Profit is post-determined, and hence
there is no uncertainty on the part its amount is not known until the
of either the givers or the takers of activity is done.
loans.
Riba can not be negative, it can at Profit can be positive, zero or even
best be very low. negative.
From Islamic Shariah point of view, it From Islamic Shariah point of view, it
is Haram. is Halal.
 Types of Riba
• Riba al Nasi’ah
Also known as Riba al-Duyun (riba on loans), Riba al-Quran, Riba al-Jahiliya,
Riba al-Jali (obvious riba) and Riba al-Mubashir (Direct Riba).

• Riba al Fadl
Also known as: Riba al-Buyu’u (riba in trade), Riba al-Hadith, Riba Ghayr
Mubashir (indirect riba), Riba al-Khafi (hidden riba).
 Riba al-Nasi’ah
• Is the primary form of Riba.
• The verses of the Quran has directly rendered this type of Riba as haram
(Riba al Quran).
• Riba al-Nasi’ah refers to the addition of the premium which is paid to the
lender in return for his waiting as a condition for the loan and is technically
the same as interest.
• The prohibition of Riba al-Nasi’ah have been confirmed in the Hadith.
 Riba al Fadl
• Riba al Fadl actually means that excess which is taken in exchange of
specific homogenous commodities and encountered in their hand-to-hand
purchase and sale as explained in the famous hadith:
‫ة‬³‫ «الذهب بالذهب والفض‬: -‫ه وسَّلم‬³‫صَّلى الله علي‬- ‫عن أبي سعيد الخدري قال رسول الله‬
‫ فمن‬،‫د‬³‫دا بي‬³‫ ي‬،‫ مثال بمثل‬،‫ة والبر بالبر والشعير بالشعير والتمر بالتمر والملح بالملح‬³‫بالفض‬
»‫ اآلخذ والمعطي فيه سواء‬،‫زاد أو استزاد فقد أربى‬
The Prophet (Allah bless him and give him peace) said, “Sell gold in exchange
of equivalent gold, sell silver in exchange of equivalent silver, sell dates in
exchange of equivalent dates, sell wheat in exchange of equivalent wheat,
sell salt in exchange of equivalent salt, sell barley in exchange of equivalent
barley, but if a person transacts in excess, it will be usury (Riba). However,
sell gold for silver anyway you please on the condition it is hand-to-hand
(spot) and sell barley for dates anyway you please on the condition it is hand-
to-hand (spot).”
 Riba al Fadl
• This hadith enumerates 6 different commodities (Rabawi items) namely:
1. Gold 2. Silver 3. Dates 4. Wheat 5. Salt 6.
Barley
• These six commodities can only be bought and sold in equal quantities and
on spot.
• An unequal sale or a deferred sale of these commodities will constitute Riba.
• Cases:
o Buying dates with cash.
o Exchanging dates for other type of dates. (2 conditions)
o Exchanging dates for barely. (1 condition)
 Riba in Conventional Banks
• Loans
• Bank accounts
• Credit cards
• Letter of credit
• Bonds
 Gharar
• The Arabic word Gharar is literally means excessive uncertainty or excessive
risk.
• Gharar refers to any transaction of probable items whose existence or
characteristics are not certain, due to lack of information and ignorance
of essential elements in the transaction to either party.
• It also means to cheat and deceive.
• Islam requires all aspects of the transaction or contract to be transparent
and known to all parties.
 Gharar
Some situations where Gharar could exist are as follows:
• The sale of items which do not exist or whose characteristics are not certain.
For example: Selling of the birds in the sky and selling the fish in the water.
• Goods that are impossible to deliver. For example: a fresh fruit during a
season it does not grow.
•A sale contract is executed without specifying the price.
• When all aspects of the contract are not known by all the parties, there is
lack of transparency. For example, selling a car without revealing its
specifications.
• Hidden costs.
 Maysir
• Maysir, literally means gambling.
• Maysir refers to the easy acquisition of wealth by chance.
• Maysir is risk taken to win without any productive activity involved and has the
possibility of losing everything.
• Maysir is prohibited in Islam because it leads to winning at the expense of others
losing, so it is socially unacceptable.
• Examples of Maysir:
o Derivatives
o Insurance
o Cryptocurrencies
 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:

• The Era of the Prophet

• The Period of Orthodox Caliphate (632 – 661 C.E.)
• Period of the Noble Companions and the Succeeding Generations
• The Umayyad and Abbasid Eras
 The Era of the Prophet
The prevailing modes of transactions during this era include:

• Partnership based on profit-and-loss sharing (PLS): Musharaka (joint

venture), Mudaraba (trust financing).
• Al qard Al hasan (benevolent loan)
• Salam (Forward) contract
• Ijarah (leasing)
• Wakala (agency contract): Trans-regional trade involved trade caravans from
Mecca to Syria and vice versa
 The Period of Orthodox four rightly-guided
Caliphs

• 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)
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)
 The Period of the Noble Companions and the
Succeeding Generations
• 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)

 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
 Modern-Day Experiments of Islamic Finance
• Mit Ghamr Local Savings Bank in Egypt of 1963 (the first modern-day trial of Islamic
banking)

• The Malaysian Pilgrims Savings Board, Tabung Haji of 1969.

• The Founding of the Islamic Development Bank (IDB) in 1975 (Purpose: foster economic
development and social progress amongst the member Muslim countries and to enhance the
growth of the Islamic finance and banking industry).
• The functions of the IDB are:
o To provide financial assistance to member countries
o To establish and operate special funds for specific purposes
o To accept deposits and to mobilize financial resources through Sharī’ah compatible modes
o To promote foreign trade, especially in capital goods, among member countries
 Modern-Day Experiments of Islamic Finance
• 1975: Dubai Islamic Bank (World first Islamic commercial bank)
• 1977: Kuwait Finance House, Bahrain Islamic Bank, Faisal Islamic Bank of Sudan and
Faisal Islamic Bank of Egypt.
• 1978: Jordan Islamic Bank.
• 1978: Islamic Finance House, Luxembourg (First Islamic bank in Europe).
• 1979: Sudanese Islamic Insurance Company (First Takaful company)
• 1983: Bank Islam Malaysia Berhad
• 1984: Iran established interest-free banking in the entire country
• 1990- now: Development period.
 Fundamentals of Islamic banking and finance
• Islamic Finance is a financial system that operates according to Islamic law .

Features of Islamic finance:

• Religious basis.
• Prohibition of interest.
• Link to real assets.
• Profit and loss sharing
• Ethical businesses
 Components of Islamic Banking and Finance
Industry
The four major components of the Islamic banking and finance industry are:
• Islamic banking
• Islamic capital markets
• Takaful
• Islamic non-bank financial institutions
What are the similarities between Islamic and conventional banks?
 Similarities Between Islamic and Conventional
Banks
• Both are commercial entities licensed by the central bank, involved in
collecting deposits from the surplus units in society and applying the
funds to borrowers, entrepreneurs or deficit units.
• Both types of banks offer current accounts for the safekeeping of funds,
payment facilities, cheque books, debit cards and without any interest or
profit.
• In fixed deposits of conventional banks and investment accounts of Islamic
banks the customers agree to deposit their funds for a fixed period,
though the return with conventional banks is a fixed interest while for
Islamic banks it is a pro-rata share in the profit.
What are the differences between Islamic and conventional banks?
Conventional Banking

Interest example: Interest example:

2% 5%

Depositors Conventional Borrowers

(Surplus Units) Bank (Deficit Units)

Funds Funds
 Islamic Banking
Profit shared at pre-agreed ratio

Depositors Borrowers
(Surplus Units) Islamic Bank
(Deficit Units)

Asset Based Financing

• Current Accounts (Qard Hasan) • Murabaha Financing (Car financing)
• Investment Accounts (PLS: • Istisna Financing (Project financing)
Mudaraba) • Ijarah Financing (home financing)
• Saving Accounts (treated as CA or Profit and loss Sharing
IA) • Mudaraba financing (Project
financing)
• Musharaka financing (home
financing)
 Islamic Banking Vs. Conventional Banking

Factors Conventional Banks Islamic Banks

Risk taking Operates based on risk Operates based on risk
transfer from the sharing between the
depositors and the bank to depositors, bank and
the borrowers or borrowers or entrepreneurs.
entrepreneurs.
Economic versus social focus Concentrates on economic Community oriented,
wellbeing and profit- encouraging
maximization principles. entrepreneurship,
promoting justness and
fairness in society,
grounded on ethical, social
and moral framework.
Price of money Money is commodity and Money is not a commodity
interest is the price of
money.
 Islamic Banking Vs. Conventional Banking
Factors Conventional Banks Islamic Banks
Fixed income versus profit and Depositors receive a fixed Depositors of investment
loss sharing interest and deposits are accounts are partners of the
considered as liability. bank and share in the profit
and loss; these accounts have
characteristics of both debt
and equity.
Deposit guarantee All deposits are guaranteed Deposits placed in current
accounts are guaranteed only.
Asset link Transactions can be purely All financial transactions
financial, with no need to be either asset
compulsion to link to real based or asset backed, with
assets. an exchange of goods and
services, making the system
more stable.
 Islamic Banking Vs. Conventional Banking
Factors Conventional Banks Islamic Banks
Size of banks Many of the global Most Islamic banks are small
conventional banks are of or medium sized.
very large size.
Bank–client relationship The bank–client relationship is Depends on the type of
that of creditor and debtor. contract, could be of partners,
principal and agent, investor
and manager, buyer and
seller, lessor and lessee.
Late payment Penalty Late payments penalty are No penalty can be charged
income in case of default, any
additional penalty if charged
needs to be donated to
charity.
 Islamic Banking
Common bank structures followed in the Islamic finance industry:
•Full-fledged banks: These banks operate as independent organizations whose sole
purpose is to provide sharia-compliant products. For example: Bahrain Isalmic Bank,
Ithmaar Bank, Kuwait Finance House.
• Subsidiary banks: Subsidiary banks are generally formed by existing conventional
financial institutions as separate legal entities. They’re managed independently from
the parent company but adhere to the parent company’s strategies. For example:
ABC Islamic (Parent: ABC), Citi Bank Islamic (Parent: Citi Bank Corporation)
• Islamic Windows: Islamic financial activities are simultaneously carried out by a
conventional financial institution that assures its clients that Islamic operations are
segregated from the conventional services occurring within the same building or in
separate branches. For example: Standard Chartered bank (same building) and
AlHilal Islamic Banking Services (branch).
What is the difference between Islamic and conventional capital market?
 Islamic Capital Market Vs. Conventional Capital
Market
Basis of
Islamic Capital Market Conventional Capital Market
Comparison
For Islamic corporations and Muslim Mainly channel the wealth of savers to
countries to raise capital in a Shari’a those who can put it to long-term
Why it exist? compliant way by selling equity in the productive use by selling equity in the
form of stocks and dept in the form of form of stocks and dept in the form of
Sukuk bonds
Customers or Only conventional profit seekers who are
Both Islamic and Conventional
Investors either providers or demanders of funds
Only allowed to offer investment
Basis of Offer investment instruments for any
instruments for projects that are
activity profitable project whether it is
useful and add a value to the
financed beneficent to the society or not
economy and society
Risk sharing and profit & Loss sharing
Risk & Return Developed to hedge against risk
“PLS”
Sukuk, Shari’a-compliant equities, Equities, derivatives (SWAPs, Options,
Products
Islamic funds, equity funds, etc. Futures, forward) and bonds
 Islamic Capital Market Vs. Conventional Capital
Market

Basis of
Islamic Capital Market Conventional Capital Market
Comparison
Issuance Must be Shari’a compliant and Only approval by regulatory authority
Process approved by a Shari’a Board is required
Types of
Based on assets, equity and dept Based on dept only
Structure
Liquidity Low High
Size of the
Small Huge
market
 Takaful
• Takaful is an alternative to conventional insurance. It involves a kind of mutual risk-
sharing arrangement among multiple parties.
• The word takaful is an Arabic term that means “guaranteeing each other.”
• Islamic principles prohibit conventional insurance because it involves interest,
gambling and uncertainty.
• The takaful concept isn’t new; it has been practiced in Islamic society since the ninth
century by Muslim merchants who were trading in Asia. They formed a fund by
mutually agreeing to make contributions to cover losses incurred because of pirates
or unpredictable natural events.
• In takaful, a group of people agree to share the risk of any potential loss, such as a
house fire, vehicle accident, or health crisis, by making contributions to the fund.
Then the takaful fund helps members when they suffer a loss.
 Islamic Insurance Vs. Conventional Insurance
Islamic Insurance “Takaful” Conventional Insurance
Based on mutual cooperation Based solely on commercial factors
Donation “Tabarru’” Contract Buying and selling contract
Free from Riba (interest), Gharar (uncertainty), Includes elements of interest, uncertainty and
and Maysir (gambling) gambling
All or part of the contribution paid by the
The premium is paid to conventional insurance
Participant is a donation to the Takaful Fund,
companies by the Policyholder, and it is owned by
which helps other Participants by providing
them in exchange for bearing all expected risks
protection against potential risks
Premium paid by Policyholder is considered as
Full segregation between the Participants’ Funds
income for the company, and belongs to the
account and the Shareholders’ Fund accounts
shareholders
Claims paid from Participants’ Fund Claims paid from Company’s Fund
In case of a deficit in the Participants’ Takaful Fund,
the Takaful operator (Wakeel) provides interest- In case of deficit, the company bears it
free loan (Qard Hasan) to the Participants’ Fund
 The Support Organizations
Various international bodies established to study, promote, develop and set standards
for Islamic finance products include:
• Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI).
(Bahrain based: Focused on development of Shariah and Accounting Standards)
• Islamic Financial Services Board (IFSB) (Malyasia based: Focused on Regulatory
standards)
• International Islamic Financial Market (IIFM) (Bahrain based: Focused on
standardization of documentation)
• International Islamic Rating Agency (IIRA) (Bahrain based: Focused on rating of
Islamic financial institutions)
• International Islamic Fiqh Academy (IIFA) (Jeddah based; General Fatwa issuing body)
Developments in the Islamic Financial Industry
Breakdown of the Global IFSI by Sector and Region (USD billion)
(2020)
Islamic Banking Share in Total Banking Assets by Jurisdiction
(3Q20)
Regional Islamic Banking Assets (USD billion) (2018–3Q20)
Islamic Banking Assets Annual Growth Rates for Various Countries
[3Q19–3Q20]
Global Sukuk Issuances and Sukuk Outstanding Trends (2004–20)
Takaful Contributions by Jurisdictions (USD million) (2019)