Fundamentals of Islamic finance and banking pdf

FUNDAMENTALS OF ISLAMIC FINANCE AND BANKING – Book Sample

Introduction – FUNDAMENTALS OF ISLAMIC FINANCE AND BANKING

The core concepts of Islamic finance are as old as Islam. Islam is not just a religion but a way of life. It provides guidance to its followers encompassing the social, religious, economic and political aspects of their lives. The Islamic law called Shariah law dictates specific dos and don’ts related to all aspects of a Muslim’s life, including commercial and financial transactions.

From the time of the Prophet Muhammad, peace be upon him (PBUH), specific financial instruments were used that were designed as per the requirements of the Shariah principles. Shariah law will be discussed in much more detail in Chapter 2 of this book.

The birth of modern Islamic finance and banking though happened in the second half of the twentieth century as an extension of Islamic economics, through the joint efforts of Shariah scholars and bankers.

The global expansion of Islamic finance and banking was accelerated by the discovery of oil, rise in petrodollars and budget sur-pluses of the Gulf Cooperation Council (GCC) countries, with the concomitant increased demand among global Muslims to bank according to their religious beliefs (Natt, Al Habshi & Zainal, 2009).

Initially Islamic banking experiments were private initiatives of individuals, but later governments in some Muslim countries significantly encouraged their growth, changing existing and developing new legislation and removing various handicaps in the predominantly interest-based environment (Ahmad, 1994).

For more than 200 years the finance and banking activities in the world have been operated on the conventional interest-based system. Individuals, businesses and gov-ernments have been completely adapted to conventional banks and an alternative to this system was unthinkable and seemed impossible. The concept of Islamic banking first emerged as an experimental Islamic bank was established in Mit Ghamr, Egypt in 1963, and the world’s first commercial Islamic bank was set up in Dubai in 1975. Being new and different from the traditional conventional banking, there is a significant lack of awareness and knowledge about Islamic banking. Educational endeavours, train-ings, seminars, conferences and the general spread of knowledge of the unique field of Islamic finance and banking are of utmost importance for its growth and acceptance in the global finance industry.

A major driving force that led to the revival of Islamic finance and banking in current times was the increasing awareness amongst the global Muslim population about the prohibition of interest in commercial transactions, mainly in banking and business operations, and their growing need to conduct their financial transactions as per their faith. This demand was predominant in the Muslim majority countries but began to grow amongst the Muslim population in non-Muslim countries also.

The operations of Islamic banks are quite similar to those of conventional banks, except that their transactions need to be free of interest and follow other Shariah law requirements. Although Islamic banking is still in its early days, starting from the feeble beginning of Mit Ghamr in 1963, it has been able to survive and grow at an unprece-dented rate over the last five decades, something not seen in conventional finance, and is now viewed as an alternative form of finance and banking. It has attracted the atten-tion of many investors and has the potential to attract new customers and grow further, earning market share.

CREATION OF MONEY AND CONVENTIONAL FINANCE AND BANKING

Before money was created, economic exchanges happened via the barter system. In the barter system one person exchanged a good or service with another person’s good or service. This system had many inconveniences. Two people had to meet up where each owned something that the other wanted. The inconveniences of the barter system led to the emergence of money as a medium of exchange. Money separated buying and selling as two separate activities. Historically, many things have been used as mediums of exchange, like livestock (cows, camels, horses), grains (wheat, barley), precious met-als (gold, silver) and finally coins and paper money.

Western commercial banking started in around the 14th century in Florence and became more established in the 18th century with the advent of the Industrial Revolution. It was established by three groups of people and to this day conventional banking shows traces of its ancestors. These groups were:

The creation of money led to the development of financial institutions whose main purpose was to bring together those with surplus money and those with a shortage of money. Financial institutions have played important roles in the economies of all soci-eties over time, collecting money from customers, providing them with safekeeping services and lending or investing these funds. This process is called financial intermedi-ation and it is the core business of banks. Financial intermediation will be discussed in much greater detail in Chapter 3.

1.             Rich and reputable merchants. Like a merchant the bank finances foreign trade, issues bills of exchange and provides capital to new business ventures.

2.            Money lenders. Like money lenders the bank pools the savings of the masses and lends it out to those with a shortage of finances and makes a profit by charging higher interest to the borrowers and paying lower interest to the savers.

3.            Goldsmiths. Like a goldsmith the bank serves as a trustee of customers’ valuables.

DEFINITION OF ISLAMIC FINANCE AND BANKING

Islamic finance and banking is a faith-based financial system and its foundation is laid down in Shariah law and the principles of Islamic economics. Islamic economics will be discussed further later in this chapter. Since the original knowledge of the system is derived from the divine source of Quran – the holy book of the Muslim faith – it supersedes scientific methods or human decisions.

The guiding principles of Islamic finance and banking emphasize fairness, justice, empathy, cooperation, entrepreneurship, eth-ics and the general good of the environment and society, not just profit maximization. This unique religion-based financial system can be better defined and understood by elaborating its distinctive features as below.

Distinctive Features of Islamic Finance

1.             Religious basis. Islamic finance is based on the rules and regulations derived from the Islamic faith and law, while conventional finance has no religious restrictions. All Islamic finance and banking contracts must be acceptable by Shariah law.

2.            Prohibition of interest. At the core of Islamic finance is the prohibition of Riba –which is interest or usury, and means an addition to the loan amount with the passage of time. Earning money from money is not allowed. It is the time value of money which is prohibited in Islam. Islam identifies money as a medium of exchange but not having intrinsic value that can earn more money. In contrast, interest payment and interest charging are at the core of conventional finance. Riba and other prohibitions in Islamic finance will be discussed further in Chapter 2 of this book.

3.            Link to real assets. To avoid money earning more money, all Islamic financial transactions are linked to a real asset and there is an exchange of goods and ser-vices, making them less risky.

4.            Bank as a partner. Conventional banks borrow funds from depositors and lend the funds to borrowers/entrepreneurs, while Islamic banks act as a partner to both the depositors and the borrowers. Islamic banks also operate as a seller in certain financial transactions.

5.            Profit and loss sharing. Conventional banks pay interest to the depositors and receive interest from the debtors to whom they lend funds. In contrast, predetermined

payments on loans are prohibited in Islamic finance; instead, the system operates on a profit and loss-sharing basis. An Islamic bank shares in the profit of the client to whom it provides financing and is also required to share in any loss incurred by the business. On the deposit side, the Islamic bank shares its profit and loss with the depositors, pro rata to their deposit amounts.

6.            More prudent selection. Being a partner to the client, Islamic banks share in both the profit and loss of the borrower’s enterprise and this encourages Islamic banks to be more prudent in selecting their clients and the projects they finance. Conven-tional banks charge fixed interest from their borrowers regardless of whether the client makes a profit or a loss, hence they are more concerned about the creditwor-thiness of the client and their ability to provide collateral rather than their business success. Islamic banks, on the other hand, give more emphasis to the feasibility of the project and the capabilities of the entrepreneur.

7.            Productive investment. Islam encourages Muslims to invest in productive enter-prises rather than hoarding their money, since idle money cannot earn any interest income. As such, Muslim depositors are encouraged to finance as partners, enjoy-ing profit as well as bearing loss. This stimulates the economy and encourages entrepreneurs to put in their best efforts to succeed, which finally benefits the community also (Kettel, 2010).

8.            Unnecessary and excessive risk. Islam prohibits any transactions that are based on excessive and unnecessary risk-taking leading to uncertainty. As such, speculative transactions are not allowed in Islamic finance.

ECONOMICS AND ISLAM

Economics in Ancient Times

Today we understand economics as the discipline that deals with the production, distribution and consumption of goods or services and wealth in general. Economic systems in societies from ancient times have been based either on religion or on capitalism.

Faith-based systems promoted justice and fairness in economic activities and encouraged the rich to share their wealth with the poor. In contrast, capitalistic eco-nomic systems operated on the concepts of survival of the fittest, competition and profit maximization.

During ancient times, economic activities like business and trade were mainly controlled by the rulers or by the religious leaders, and some rich and powerful merchants. Hence the profits generated were mostly consumed by the ruling elite, priests and rich merchants, and only small portions trickled down to the public.

During the 13th century, the below interlinked economic concepts began to appear and were the topic of significant discussions and debate.

Justice in economic exchange. The ancient Greek philosopher Aristotle considered the price of any good to be its intrinsic value, while according to the Romans the price of goods was decided by the factors of demand and supply and the contracting parties played a role in finalizing the price. On the other hand, Christian theologians believed that the intrinsic value meant the usefulness of the good and this would ultimately decide the price. Islam also recommends a just price for goods and services.

Private property. In their original form all three Abrahamic religions of Judaism, Christianity and Islam considered property to be ultimately owned by God with man serving only as its steward, and as such all property should benefit society. In Islam, the last of the Abrahamic religions, this view still holds and has a significant effect on Islamic economics and Islamic finance. The Church moved away from this view in around the 5th century and itself became the owner of substantial property and wealth. In the modern economy property is privately owned and is one of the factors of production.

Money, usury and prohibition of interest. In the early 4th century Aristotle opined that money was only a medium of exchange, without any intrinsic value of its own; hence money cannot earn money by itself.

A complete ban on usury and the prohibition of interest was common to all three of the Abrahamic religions and not unique to Islam only. According to the Judaic belief, interest could not be charged from one’s brother, and that was interpreted as another Jew, basically suggesting that interest could be charged from those of another faith. In the case of Christianity, ‘brother’ was considered as all human beings. Both the Old and the New Testament forbade earning from usury.

Initially, Christian theologians applied a total ban on usury, which over time changed to the prohibition of excessive interest only. The ban on interest was repealed in France in 1789 and in the Vatican in 1838 (Schoon, 2016). Islam is the only religion in which a total ban on any form of usury or interest continues to date. Some of the factors that contributed to Western societies’ gradual acceptance of interest in their economic life included the replacement of agriculture by the Industrial Revolution, the role of demand and supply in determining price, the acceptance of money as a fac-tor of production and the separation of the Church from the State (Schoon, 2016).

Modern Economics

Adam Smith, the renowned economist whose works are the foundation of modern economic thought, with his seminal book An Inquiry into the Nature and Causes of the Wealth of Nations (1776), said during the beginning of the Industrial Revolution that money or capital was a factor of production, like land or labour. As such it had a cost, not based on usury but on the risk and opportunity cost associated with it. Adam Smith believed in the free market concept, competitive forces and prices determined by the demand–supply mechanism.

A significant economic theory defined by him was the concept of economic scarcity. According to this concept people had unlimited wants, while the resources available to meet these wants were limited. This leads to the classic economic problem. Islamic economics differs fundamentally from Adam Smith’s con-cept of economic scarcity, as will be discussed in the next subsection.

The modern economic system is described as a network of relationships between households, businesses and governments involved in the economic activities of production, distribution and consumption of goods and services in a manner that protects the rights of future generations and of the environment. Globally there are different economic models operating, and these differences are derived from the role of markets and governments and of morality and justice in these models.

The four classic models, as discussed by Askari, Iqbal & Mirakhor (2015), are briefly defined below. The fifth model can be defined as Islamic economics, and this is covered in more detail in the next subsection.