Introduction and

Development of Islamic
Financial System
Hidayatul Ihsan

Outlines
1. Fundamental principles of Islamic
financial
2. The prohibitions of riba
3. The development of Islamic
financial institutions

Part I
Fundamental principles of
Islamic financial

Financial system
Economic
system

Financial
System

Capitalist
Financial
system

Islamic
Financial
system

Source: Shahul
(2009)

Marist
Financial
system

 All Western economic systems i.e. capitalist and

socialist claim to achieve human welfare
Capitalist attain human welfare through selfinterest
Satisfying individual self-interest leads the economic
development as a whole

Marist system create social welfare by

ownership and centralization of production by
the state
All these system have been unsuccessful in
achieving social welfare for all (Chapra, 1992)

Islamic finance
Islamic financial system is regarded
as the alternative to the Western
financial system
There has been a rapid growth of
Islamic finance in the last four
decades
There are unique characteristics and
features of Islamic financial system
that distinguish it from the
conventional counterpart

 Finance related to resource allocation,

management and investment
The adjective Islamic indicates that Islamic
finance is built on some principles underlined by
shariah
Some of the principles are : prohibition of riba,
prevention of gharar (ambiguity), prohibition of
maysir (gambling), prohibition of unethical
activities such as pornography, alcohol,
prostitution, monopoly, introduction of religious
alms giving (zakat) and co-operation for the benefit
of the society

What is shariah?
Shariah literally means the way or path
to a watering place or a clear path to be
followed or the which leads to a source
Technically shariah means the canon law
of Islam
Shariah is set of norms, values and laws
that governs the Islamic way of life
Thus, shariah governs all aspects of Islam
including faith, worship, economic, social,
political and cultural aspects

 In Islam, each aspect of human life

cannot be treated in isolation i.e.
ibadah and muamalah
The sources of shariah : Quran,
sunnah and ijtihad

Value proposition of IFS

Tawhid Gods unity and sovereignty
Rububiyyah- divine arrangements for
nourishment and directing them things
towards their perfection
Risalah- prophethood and guidance
Akhirah- belief in accountability on the
day of judgment
Istikhlaf- mans role as Gods vicegerent
on earth

Tazkiyah- purification plus growth

Kafalah Social solidarity
Adalah Justice
Falah success in this world and the
hereafter

Some applicable characteristics of

Islamic economic system
Every individual has a right to seek
economic well-being, there should be
clear distinction between lawful and
unlawful
Islam recognizes ownership but
should spend it judiciously and not
keep it idle
Individual may retain surplus, Islam
seeks to reduce the surplus for the
well being of the community

 Islam prevents the accumulation of

wealth in few hands
It aims at social justice without
inhibiting individual enterprise

Part II
The prohibitions of
riba

Riba
Definition and classification
The Quran and hadith specifically
prohibits riba in economic
transactions
Riba has been translated into English
as usury or interest
Saleh (1992) unlawful advantage
by way of excess or deferment

 Two categories of riba: riba al fadl and riba

al nasia
Riba al-fadl excess of one of the
exchange counter values. E.g. the
exchange of 2 kg of low quality rice for 1
kg of high quality rice
Riba al-nasia excess by way of
deferment of completion of exchange. E.g.
a loan of Rp 1 million for a deferred
repayment 1.1 milion a month later

Reasons for the prohibition

of riba
Pre-determined fixed rate of return leads to
injustice One party bears the risk, while
the other receives a rewards regardless of
the outcome of the use of the borrowed
amount
Leads to the concentration of wealth by
transferring wealth from the poor to the rich
Increase the instability of the trade cycle,
causing more violent fluctuations due to the
high rate of interest

Misconceptions about riba

Riba is only usury and not interest
Riba is compound interest and not
simple interest
Only interest for consumption is
prohibited, not on investment loan
Because of time value of money,
interest should be allowed
Bank interest is not prohibited because
it is not exploitative

Part III
The development of Islamic
financial institutions

 In the heyday of Muslim civilization,

two important institutions were baitul
maal and awqaf
They were replaced by Western
economic institution after the
colonization of Muslim lands

History of Islamic banks and

financial instituions
The first Islamic bank established
was at Mit-Ghamr, in Egypt in 1963.
Bank operation: saving and loan
fund, investment fund and social
service fund
The bank was took over by Nasser
socialist regime in 1967

Classification of Islamic
banks
Islamic special purpose banks> to serve
special class of clientele. E.g Islamic bank of
western Sudan
Islamic development bank to foster the
process of socio- economic development among
its member. The clientele are usually
governments
Islamic commercial banks to make profit
within Islamic system
Non banking do not perform banking
functions, e.g. pilgrims fund

Islamic banks in Indonesia

Established in 1992 Bank
Muamalat Indonesia
Now there are 12 full-fledged Islamic
banks and 22 Islamic business units