Islamic Finance and Banking

Prepared By:
Dr. H. M. Mosarof Hossain
Professor
Department of Finance
University of Dhaka
mosarof@du.ac.bd

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 Islamic economics

It is a branch of knowledge which helps to realize

human well being through an allocation and
distribution of scarce resources that is in conformity
with Islamic teachings without unduly curbing individual
freedom or creating continued macroeconomic and
ecological imbalances. Also according to Chapra and
many other Scholars; there are 4 sources of Islamic
systems; they are;
1-) Quran, such a divine sources
2-) Sunnah, the sayings and practices of the Prophet
Mohammed (pbuh)
3-) Ijma, the common belief of Muslim scholars
4-) Qiyas, the other principles that are compared to those
three sources.
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Islamic economics or Islamic commercial
jurisprudence or fiqh al-mu'malt refers to the rules
of transacting finance or other economic activity in a
Shari'a compliant manner, i.e. a manner conforming to
Islamic scripture (Quran and sunnah). Islamic
jurisprudence (fiqh) has traditionally dealt with
determining what is required, prohibited, encouraged,
discouraged, or just permissible, according to (what
Muslims believe to be) the revealed word of God
(Quran) and the religious practices established by the
(Islamic) Prophet (sunnah).

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This applied to issues like property, money,
employment, taxes, along with everything else. The
central features of an Islamic economy are often
summarized as:
(1) the "behavioral norms and moral foundations"
derived from the Quran and Sunnah;
(2) collection of Zakat and other Islamic taxes,
(3) prohibition of interest (riba) charged on loans.

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In islamic economic system by Islamic activists
and revivalists are that the gap between the
rich and the poor will be reduced and
prosperity enhanced by such means as the
discouraging of the hoarding of wealth, taxing
wealth (through zakat) but not trade, exposing
lenders to risk through Profit sharing and
venture capital, discouraging of hoarding of
food for speculation, and other sinful activities
such as unlawful confiscation of land.
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 Objectives of Islamic economics

a. Economic well-being and the moral norms of Islam;

b. Universal brotherhood and justice;
c. Equitable distribution of income; and
d. Freedom of the individual within the context of social
welfare.

Imam Al-Ghazali, an Islamic philosopher, contended that the

very objective of the Islamic jurisprudence is to promote the
welfare of the people which lies in safeguarding their faith,
their life, their intellect, their posterity and their property; and
that therefore whatever ensures the safeguard of these five
serves public interest and is desirable.

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 Objectives of Islamic economics
The main objective of islamic economy is to follow maqasid
al-shariah thats target is to promote the welfare of human
beings, which lies in safeguarding their religion, selves,
minds, progeny and wealth. Whatever ensures and
safeguards these five fundamentals serves public interest
and is desirable. Whatever hurts them is against public
interest and its removal is desirable. (Al-Ghazali). The
structural elements of maqasid in islamic economy are
explained below:
1. Religion: The vision of well-being
Needs and embellishment take such as effect on religion as
long as the worldview of shariah extends through ijtihad
to encompass are ideas, rules, measures and values to
match rising economic wants in the everlasting endeavour
to satisfy those.
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 Objectives of Islamic economics
2. Self: The central goal
Self is human life which is the goal of well-being as implied by
the verse:It is He who created for you all of that which is on
earth. (Al-Quran, 2:29). Quran says: We have certainly honored
the children of Adam and carried them on the land and sea and
provided for them of the good things and preferred them well over
much of what we have created (Al-Quran: 17:70).
3. Mind: The human resource
Mind is the human resource that thinks, evaluates, plans,
manages and produces the goods (tayyibat) of well-being subject
to shariah. The first five verses to Muhammad (p.b.u.h.) are:read
in the name of your Lord who created, - created man from a
clinging substance. Read and your Lord is the most Generous,
Who taught man by pen. Taught man that which he knew not (Al-
Quran 96:1-5). 8
 Objectives of Islamic economics
4. Progeny: Intergenerational continuity
Intergenerational responsibilities depend on family,
and social and government institutions in lobbying
peoples support. The guiding principle is the
Quranic verse: Let the one of means spend
according to his means: and the one whose
resources are restricted, let him spend according to
what Allah has given him. Allah puts no burden on
any person beyond what He has given him (Al-
Quran 65:7).

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 Objectives of Islamic economics
5. Wealth: The material economic resource
Material economic resources must run abundantly in
the economy to activate human resources in the
pursuit of well-being and intergenerational continuity.
Wealth is the mean to achieve goals and targets of
human being. Shariah recognizes and fosters all
customary rights of private property under the
provision that wealth is a trust from Allah (s.w.t.) to test
how his servants deliver moral and social obligations
through the management of their wealth. Believe in
Allah and His messenger, and spend out of what He
has made you vicegerents(Al-Quran 57:7).
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 Why Islamic economics?
The modern industrial environment has brought with it
unprecedented socioeconomic problems affecting
human well-being beyond the traditional shariah
scholarship, even though the core principles of islamic
economics originated in the works of early shariah
scholars who laid down the foundations of maqasid
and utility theory. Islamic economics is therefore, a
newly emerging discipline that takes the lead in
resolving newly arising economic issues from the
viewpoint of maqasid that has emerged to satisfy new
needs in relation to the mind, the productive human
resources.
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The Three Central Economic Problems

1. Production decision (What to produce) it covers

nature, volume and pricing of goods. Prices are
fixed by God. He alone contracts and expands the
means of livelihood, and I wish to meet my
sustainer having no claim of injustice being made
against me in respect of blood and wealth.

2. Management decision (How to produce) islamic

economy prohibits riba and emphasised on risk-
sharing through mudarabah and musharakah
rather than external debt financing.
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 The Three Central Economic Problems
3. Distribution decision (For whom to produce)- in
islamic economics there are wage, rent and profit for
different factors of production. Money capital shares
the same income and profit with the entrepreneur on
a PLS basis thereby giving room to favorable
distributional consequences in terms of employment
and labor-friendly technology. In this economy for
ensuring justice there will be applying zakat and
waqf those will minimize poor-rich gap in the society.

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 Economics of Riba
i. Riba is any earning, income, profit or benefits being
earned, taken or received through wrong means, bad
intentions, shady practices or wicked participation.
Ii. It is not only treated as immoral, unjust filthy but
furthermore threat to socioeconomic life of the society.
iii. It leads to crimes of various nature, through cruelty,
humiliation, exploitation, self- importance,
discrimination, power, selfishness, greed and self-
esteem.
iv. It is as a combination of evil and sins and bad
practice to earn & gain.
v. It brings instability in the community life and the
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source for the increase of inflation.
 Economics of Riba
vi. It is immoral, unethical, unjustified commercial, economical,
trading, business, political, social, cultural and traditional
practices and activities to gain benefit at individual, collective or
institutional level. People who indulge in riba shall be raised like
those who have been driven to madness by the touch of devil.
That is because they say that riba-based transaction is just like
trading, while Allah has permitted trade and prohibited riba.
Hence those who have received the warning from Allah and
have stop accordingly, may have what has already passed, their
case being entrust to Allah but those who revert to riba-based
dealings, shall be the inhabitants of the hell-fire and abide
therein forever. (You must know that) Allah deprives riba from all
blessings and blesses charity; He loves not any ungrateful
sinners.
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 Economics of Riba
In Holy Quran (2:278-79), Allah says, O you believers! Fear
Allah and give up riba that remains outstanding if you are true
believers. Watch out, If you do not obey this directive, then Allah
declares war against you from Himself and from His Prophet.
But, if you give up your outstanding riba, then you can claim
your principals. Neither should you cause harm with riba to
others, nor should others harm you. Prophet Muhammad (May
Peace Be Upon Him) said at the last Pilgrimage, all riba of
jahilliya is null and void. In this respect, the first riba I (May
Peace Be Upon Him) withdraw that the borrowers owe to my
uncle Abbas; it is cancelled completely. (Muslim) The Prophet
(May Peace Be Upon Him) cursed all those who take riba, who
give riba, who write a riba contract and the two witnesses to a
riba contract. He (May Peace Be Upon Him) further said: "They
are all alike (in fault). 16
 Economics of Riba
vii.Riba must be eliminated from the financial transactions.
Nothing is more horrific as compared to riba that Islam has
prohibited. Nothing is more dreadful than riba, is remains in
widespread threatening socio economic activities in both theory
and practice.

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 Economics of Financial System
Financial system is a complex set of financial institutions and
markets that bring together lenders and borrowers consisting of
banks, insurance companies, mutual funds and other finance
companies. The main objective of this system is to mobilise
large amounts of relatively small savings and pool them
together to channel them for productive investments in the
economy directly through markets or indirectly through financial
intermediaries. Financial institutions also develop instruments,
techniques and products that meet the needs of both lenders
and borrowers. Central banks also carry out monetary policies
through financial institutions for supporting economic growth of
the country by producing goods and services and creating
employment.

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The structure of Islamic Financial System

Under islamic financial system, islamic financial

markets, institutions and instruments operate in line
with shariah rules and principles. This system is
governed by the following factors:
a) Transaction cost- costs incurred for financial
structuring, legal documentation, accounting
treatment and administrative follow-up.
b) Economic information- past track records, current
financial position and future investment prospects.

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 Islamic Financial Markets

Financial market mechanism deals with different

types of financial instruments for exchanging funds
from surplus units to deficit units by complying with
shariah rules and principles specially eliminating
riba, gharar and maysir is known as islamic financial
market.

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 Islamic Financial Institutions

Financial institutions deal with different types of

financial instruments for exchanging funds from
surplus units to deficit units by complying maqasid of
islamic financial system specially eliminating riba,
gharar and maysir for achieving goals of financial
system are known as islamic financial institution.

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 Role of Islamic Financial Institutions

i. To make a link between surplus groups and

deficit groups.
ii. To collect relatively small savings from individuals
and institutions and transfer them to businesses
for investment and production purposes.
iii. To gather and process information about the
economic conditions of markets as well as market
players.
iv. To ensure market efficiency by reducing cost for
raising funds and maximizing return on
investment.
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 Role of Islamic Financial Institutions

v. To transform relatively short-term liabilities into

long-term assets.
vi. To facilitate the mitigation, transfer and sharing of
risk.
vii. To provide maturity intermediation.

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 Distinct features of Islamic Financial
Institutions

i. Islamic financial institutions use various

contracts that are in line with shariah teachings.
ii. They use equity as well as debt-based financial
instruments for the mobilisation and use of
funds.
iii. They buildup and maintain long-term
relationships in profit-and-loss sharing
arrangements.
iv. They may imply higher costs and unique risks.

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 Distinct features of Islamic Financial
Institutions

v. They face certain risks that are associated with

specific business models and islamic contracts
in financial intermediation.
vi. They are faced with the rate of return risk,
displaced commercial risk, fiduciary risk,
shariah compliance risk and reputation risk.
vii. Existence of shariah advisory board that
approves introduction of any new product.

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 Islamic Financial Instruments

From the shariah point of view, every contract is

considered to be legal and lawful as long as it
does not contain any prohibited elements, such as
riba, gharar and maysir. Islamic instruments are:
A: Deposit instruments- Al-Wadeah current account (AWCA),
Mudarabah savings account (MSA), Mudarabah term depost account
(MTDR), Mudarabah special notice account (MSNA), Mudarabah hajj
savings account (MHSA), Mudarabah special savings account (MSSA),
Mudarabah savings bond (MSB), Mudarabah monthly profit deposit
account (MMPDA), Mudarabah monthly savings account (MMSA),
Mudarabah waqf cash deposit account (MWCDA), Mudarabah NRB
savings bond account (MNSB), Mudarabah foreign currency deposit
account (MFCDA), Students mudarabah savings account (SMSA),
Mudarabah farmers savings account (MFSA).
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 Islamic Financial Instruments
B: Investment instruments:
i. Bai modes- Bai-Murabaha, Bai-Istijrar , Bai-Muajjal, Bai Salam, Istisnaa, Bai-
As-Sarf
ii. Share modes - Mudaraba, Musharaka
iii. Ijara modes - Hire Purchase Under Shirkatul Melk
iv. Investment Scheme- House Hold Investment Scheme, Investment Scheme for
Doctors (ISD), Transport Investment Scheme (TIS), Car Investment Scheme
(CIS), Small Business Investment Scheme (SBIS), Micro Industries Investment
Scheme (MIIS), Agricultural Implement Investment Scheme (AIIS), Real Estate
Investment Program (REIP), Real Estate Investment (Commercial & Working
Capital), Agricultural Investment of IBBL , NRB (Non Resident Bangladeshi)
Entrepreneurs Investment Scheme(NEIS), Women Entrepreneurs Investment
Scheme (WEIS)
v. Rural Development Scheme

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Differences between Islamic and conventional banking

1. The functions and operating modes of conventional banks are

based on fully manmade principles whereas the functions and
operating modes of Islamic banks are based on the principles of
Islamic Shariah.
2. The investor is assured of a predetermined rate of interest,
whereas in contrast, it promotes risk sharing between provider of
capital (investor) and the user of funds (entrepreneur).
3. It aims at maximizing profit without any restriction, whereas it
also aims at maximizing profit but subject to Shariah restrictions.
4. It does not deal with Zakat, whereas in the modern Islamic
banking system, it has become one of the service-oriented
functions of the Islamic banks to be a Zakat Collection Centre
and they also pay out their Zakat.

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Differences between Islamic and conventional money
markets
5. Lending money and getting it back with compounding
interest is the fundamental function of the conventional banks,
whereas participation in partnership business is the
fundamental function of the Islamic banks. So we have to
understand our customer's business very well.
6. It can charge additional money (penalty and compounded
interest) in case of defaulters, whereas the Islamic banks have
no provision to charge any extra money from the defaulters.
Only small amount of compensation and these proceeds is
given to charity. Rebates are given for early settlement at the
Bank's discretion.
7. Very often it results in the bank's own interest becoming
prominent. It makes no effort to ensure growth with equity,
whereas it gives due importance to the public interest. Its
ultimate aim is to ensure growth with equity.
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Differences between Islamic and conventional money
markets
8. For interest-based commercial banks, borrowing from the
money market is relatively easier, whereas for the Islamic
banks, it must be based on a Shariah approved underlying
transaction.
9. Since income from the advances is fixed, it gives little
importance to developing expertise in project appraisal and
evaluations, whereas since it shares profit and loss, the
Islamic banks pay greater attention to developing project
appraisal and evaluations.
10. The conventional banks give greater emphasis on credit-
worthiness of the clients, whereas the Islamic banks, on the
other hand, give greater emphasis on the viability of the
projects.

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Differences between Islamic and conventional money
markets
11. The status of a conventional bank, in relation to its clients,
is that of creditor and debtors, whereas the status of Islamic
bank in relation to its clients is that of partners, investors and
trader, buyer and seller.
12. A conventional bank has to guarantee all its deposits,
whereas islamic bank can only guarantee deposits for deposit
account, which is based on the principle of al-wadiah, thus the
depositors are guaranteed repayment of their funds, however if
the account is based on the mudarabah concept, client have to
share in a loss position.

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