Chapter 1
Introduction to Islamic
Finance
Term in Arabic Meaning
Reba Interest
Al-wadiah Safe keeping
Bai'muajjal Deferred-payment sale
Bai'salam pre-paid purchase
Zakat Islamic tax
Halal lawful
Haram unlawful
Ijara leasing
Mudaraba profit-sharing
Mudarib Entrepreneur-borrower
Murabaha Cost-plus or mark-up
Musharaka Equity participation
Qard hasan Benevolent loan (interest free)
Gharar Uncertainty or chance
Sukuk Islamic bond
Qirad Mudaraba
Rabbul-mal Owner of capital
Shariah Islamic law
Shirka Musharaka
Introduction
One reason for the emergence of specialized financial institutions
was that those who save money in a society are not generally the
ones who need money for productive or other purposes;
intermediaries were needed.
Banks were the first to fill the gap, and other institutions followed.
They brought the savers and users of money together for their
mutual benefit. Banks came into being when trade and commerce
were the dominant economic activity and industry was yet to
assume importance.
These institutions constitute the financial markets for money,
stocks and foreign exchange.
In practice, Islamic financial institutions operate side by side and
in competition with their conventional counterparts across the
world, including in Muslim countries.
What is finance?
Finance is concerned with the provision and management of money and
credit, including related assets, with a view to promoting the growth of the
real sector, which is the sector that actually produces goods and services.
This view of finance focuses on the linkage between the financial and
the real sectors of an economy.
Each supports the other in boosting economic progress that is
conducive to human well-being
Exchange eventually takes place between real sector outputs, and
money operates only as a go-between.
Every financial transaction has a real goods or services counterpart
Finance essentially belongs to the macro branch of economics.
Production, trade and consumption transactions in markets for goods
and services involve both the financial and real sectors.
Economics
Economics is a branch of Social Science that deals with production,
distribution & consumption of goods and services.
Purpose of Economics (in
General)
To utilize limited resources in a way that maximum needs of all
human beings and maximum wants of all human beings are met so
that prosperity is ensured in human society
Economics in Islamic
Perspective
To utilize adequate resources in a way that basic needs of all
human beings and lawful wants of maximum human beings are met
so that disorder be reduced from human society
Capitalism:
Capitalism is an economic system which is based on the of concept
of the private and uncontrolled ownership of wealth.
Synonyms: Free economy; free market system; self- regulating
market; unplanned economy; interest-based saving system
Socialism:
Socialism is an economic system which is based on the concept of
state ownership of wealth
Synonyms: State ownership; planned economy; controlled
economy
Comparison of Capitalism & Socialism
Capitalism Socialism
Determination of Every individual has No individual has the
Priorities unconditional right to right to participate in
participate in any business any business
to maximize profits. independently.
Concept of selfish interest. Concept of collective
interest
Supply & demand will State will determine
determine the priorities. the priorities as per
the overall planning
Allocation of Market forces will decide Govt. will decide where
resources where to invest resources to allocate resources.
Capitalism Socialism
Distribution of Land – Rent Land – Rent fixed by Govt.
Income Labor – Wage Labor – wages fixed by Govt.
Capital – Interest
Entrepreneur - Profits
Development Market forces will decide Govt. will Decide
Flaws of Capitalism
No bindings/ restrictions while maximizing profits.
Blindly follows market forces that creates exploitation of labor &
poor people.
No moral value limitations.
Monopolies & Alliances are created that exploit the society as a
whole.
Government & Industrialists join hands for mutual
Flaws of Socialism
The other extreme of not even giving the natural freedom.
Perfect Planning is assumed by Govt. ?
Governments are assumed to be angels which can’t commit a
deliberate mistake.
Cannot work without forceful dictatorship.
Difference between Commodity &
Currency
Conventional & Islamic Banking
Conventional Banking Islamic Banking
Conventional Banking prices moneyIslamic banking process goods and
services which creates real wealth in
the society leading to economic will
being
Is based on fixed return on both Is based on profit sharing on deposit
sides of the balance sheet. side, and on profit on assets sided
Does not involve itself in trade and Actively participates on trade and
business production.
Depositors get a fixed rate Profit shared with depositors, higher
regardless of the banks profitability, the banks profit, higher the
thus insulating them from the banks depositor's income.
true performance.
The significance of finance
in modern economies
The significance of finance in modern economies:
Finance is the lifeblood of trade, industry and commerce.
The foremost characteristic of financial institutions is to maintain
asset liquidity within the system and develop it in the economy.
Finance can be an effective instrument for improving efficiency and
the better utilization of resources
Well-functioning financial markets are a necessary condition for real
sector growth and societal prosperity.
Finance is a source of economic, social and political power.
Money and
Economies
Money is a thing, an object that carries a perceived value.
The essence of money lies in what it does.
The functions of money give it substance and significance
independent of time and space.
Money emerged as a solution to overcome the difficulties of the
barter system.
Its primary function:
As a medium of exchange
Measure of value for comparisons
A standard for deferred payments
Storing value (i.e. wealth in liquid form)
A unit of account, i.e. the currency, in terms of which the
values (prices) of commodities in business transactions would
be expressed.
Money and Prices
One characteristic of all measures is that their own value,
relative to what they measure, remains unchanged in the
measuring process.
Money is a different sort of measure in that its own value is
never independent of the value of what it measures.
The measure of money value is its purchasing power.
If a money unit buys less than before, its value is reduced; it is
increased if it buys more.
So, we buy less when prices rise and more when they fall,
other things remaining unchanged.
Thus, the purchasing power of money or its value varies
inversely with changes in the prices of goods and services in
an economy.
The distinctive features of the
Islamic approach to finance
A survey of the literature discloses that there are no uniform
features of the Islamic approach to finance; an individual’s
selection is purposive.
Three interpretations of this approach are clearly identifiable,
although they do tend to overlap.
First, there are those who see the system’s humanistic theory
and rule compliance as being its distinctive features.
Second, there is the group who think it is the financial
instruments that the systems uses that set it apart.
Third, there are still others who consider the regulations and
procedures that oversee the systems in operation as its
distinguishing features.
Ban on giving or taking interest
Islamic finance emerged and derived its strength essentially
from the ban Scripture imposed on the institution of
interest.
Time value of money
Money by itself is barren. Marking time alone does not
create anything. So, Islam in general does not permit
putting a time value on money.
Avoidance of gharar or indeterminacy
These principles lie at the heart of the celebrated Islamic
notion of gharar (uncertainty), translated as hazard.
Contractual relations must, as far as possible, be free of
gharar.
Participatory financing
Participatory financing rests on sharing business risks and the
profits of business.
Enhanced customer protection
Laws protecting customers from manipulation and cheating
have increased over time within and across nations.
Asset-based finance
This is not correct. Any transaction taking place in the financial
market must have a counter-transaction somewhere in the real
goods market.
Why ban interest?
Believers require no argument as to why they must
avoid interest
Interest payments cannot meet the norms of social
justice at the macro level
The institution of interest operates against equity
financing of business because, among other things,
interest payments are treated as cost elements which
are allowable deductions for corporate taxes, as
opposed to dividends.
Overview: The origin and
evolution of Islamic finance
The first financial institution, known as the baitulmal or the
public treasury, was established by the Prophet (peace be upon
him) himself.
Umar Ibn al-Khattab, the second caliph, who gave the institution
of baitulmal a distinct entity (in 644 AD) and identified its
sources of revenue, including zakat (a charge on wealth), kharaj
(land revenue), jizia (poll tax), custom duties, tolls and sadaqa’at
or donations.
It emerged around the middle of the twentieth century, and
gained momentum after the 1960s with the rise of Islamic
revivalist movements across the world.
The growth pattern and structure of the fast-expanding
Islamic finance differs from country to country, and common
and cohesive elements are yet to be established.